http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights.htmlEconomic Insightsen_usCopyright 2012 Lord Abbetthttp://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/greek-tragedy-averted-for-now.htmlA Greek Tragedy Averted—for Now<div class="everything">
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<h3><i>While the Tsipras government has bought itself some time, the possibility of a Greek exit from the eurozone remains quite real—as does the risk to global financial markets.</i></h3>
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<p>Greece and the European Union (EU) have bought themselves four months before they must re-engage their negotiations. The reprieve is welcome, and shows a clear desire by both sides to reach an accommodation; but a Greek exit, even an unraveling of the common currency, remains a possibility. Arduous negotiations are still ahead for Greek prime minister Alex Tsipras and finance officials from other eurozone nations. And the potential for failure in the next round of Greek–EU talks carries immense risks, including a financial crisis that would spread quickly across the Atlantic, east to west.</p>
<p>Still, probabilities presently favor some accommodation among these negotiators to hold together the eurozone and buy still more time to resolve the Continent’s ongoing fiscal–financial crisis. The terrifying nature of such a prospect alone—and other narrower calculations of national interest as well—make it clear to all that they have too much to lose from failure. Still, investors need to know the downside—if not only to brace their portfolios for it immediately but also to make plans for such adjustments should the probabilities shift. &nbsp; &nbsp;</p>
<p><b>The Disaster Scenario<br>
</b>If the only problem were Greece, Europe would have little reason for fear. Greece is, after all, small. Its economy amounts to little more than 6.0% of the German economy and much less of the entire eurozone.<sup>1</sup> All Athens’s public debt amounts to barely 1.0% of European bank assets.<sup>2</sup> But a great threat remains nonetheless because a Greek–European rupture could start a chain reaction of defaults or restructurings among the rest of the Continent’s beleaguered periphery.</p>
<p>Even if Greece or these other nations were to stay in the common currency, a denial of support would force Athens to default on or reschedule its existing debt. Creditors in such a case would naturally lend less freely to all the troubled countries of Europe’s periphery and demand higher interest rates to cover the perceived risk. Such difficulties would raise the demands for EU aide, perhaps to unsupportable levels. Higher financing costs and less credit availability could then force defaults on, or reschedulings of, these countries’ debts, whatever other EU aid was available and whatever their former commitment. Were Italy, say, or Spain, and perhaps France and Belgium to default or restructure, the loss of wealth among financial institutions and other creditors would reach proportions that could threaten the stability of the European financial system and so threaten a still deeper economic decline than already exists in Europe. These events also would threaten the world financial system and the global economy, for though U.S. banks, for instance, own little Italian, Spanish, or Greek government debt, they do hold a lot of the obligations of financial institutions that do own a substantial amount of such sovereign debt.</p>
<p>The ensuing crisis would be large and unmanageable even if these questionable credits were to remain inside the currency union. If those reneging on their obligations were expelled from the eurozone or choose to leave, the crisis could get infinitely more severe. At the very least, such a move would create tremendous administrative confusion. If Greece, for instance, were to return to the drachma, how would Athens treat its outstanding euro-denominated debt? Given the state of that country’s economy and its public finances, an effort to honor the obligation in euros would certainly present a dubious prospect. The same concerns would emerge with Spain, Italy, and others. If Greece or one of these other countries were to convert the debt into their revived national currencies, the losses from depreciation would immediately destroy still more wealth and continue to do so with further depreciations going forward. Europe’s financial system would then become still weaker, deepening any crisis there and around the world. &nbsp;&nbsp;</p>
<p><b>Although Possible, Such Disasters Are, However, Improbable<br>
</b>If such terrible prospects alone will likely motivate Greek and EU negotiators to avoid a rupture, there also are narrower, more calibrated interests that will prompt both sides to come to an accommodation or at least paper over differences in a muddle for which the EU has become infamous during this crisis. It may have been a mistake for Greece to even join the euro, but having done so, it has much to lose by leaving it now—something Athens knows could easily follow from intransigence. Other nations involved—Italy, Spain, France, Belgium, et al—have similar benefits to lose from an unraveling of the union, or their place in the union, even if at the start it may have been a bad idea for them to join as well. Nor do the Germans—crucially important because they are Europe’s paymasters these days—want to see the euro threatened.&nbsp;</p>
<p>Greece offers an illustration of what all the poorer countries on Europe’s periphery stand to lose. For one, the union and the eurozone have brought it huge wealth transfers for the rich regions of Europe. The EU and the eurozone have largely paid for highways, bridges, ports, and other important pieces of economic and social infrastructures that had not existed and would not exist were it not for membership. The ability of people to move freely across the union’s borders has provided a great benefit as well. Greece has relatively few sources of income, but the nation benefits greatly from remittances from its nationals living and working elsewhere in the more prosperous areas of the EU and particularly the eurozone. An end to the affiliation would close down these important transfers as well. A return to a depreciated Greek drachma or Italian lire, or whatever, might help exports, but savers in these countries would quickly lose global purchasing power, a loss of wealth, potential credit, and investment that would weigh on the economy. To be sure, Greece’s new government probably does not count these savers as constituents, and so cares little for them, but it does care deeply about the more general economic hardship that would surely accompany such a wealth loss. Italy, Spain, and others could make very similar calculations.&nbsp;</p>
<p>The Germans also have narrow pro-euro interests. It is surely ironic that Berlin, of all European governments, was most skeptical of the common currency, and yet Germany has benefited especially from it. To see why, consider where the German exports would be if the country still used its deutschmark. Money is pouring into Germany, as the only large and viable economy on the Continent. Such flows would have pushed the deutschmark up to astronomical levels, pricing German exports off global and even European markets. Especially because the euro encompasses many weaker economies, it has declined in value and certainly stayed lower than a German deutschemark would have, protecting German producers by allowing them to price their products much more competitively than they otherwise could. Berlin, no doubt well aware of the effect, has every interest in protecting the eurozone, and, what is more, keeping its membership broad. It needs an agreement to secure this arrangement. &nbsp; &nbsp;</p>
<p><b>A Tentative Conclusion &nbsp;&nbsp;<br>
</b>Risks remain, and great risks they are. For that reason alone, it is fair to say that danger for American investors comes from the east. But for all the reasonable fears and concerns, the interests of all involved argue that the eurozone will avoid such a disastrous outcome, even if it involves endless negotiations and a glossing over of differences. No doubt, the Continent’s fiscal–financial crisis would then remain ongoing, but that is better than the alternative. If investors need to remain aware and wary of the potential downside, the probabilities at the moment do look more benign.</p>
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Mon, 2 Mar 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-will-growth-be-roaring-or-boring.htmlU.S. Economy: Will Growth Be Roaring, or Boring?<div class="everything">
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<h3><i>Here’s a look at key indicators—and what they signal for the pace of U.S. economic activity.</i><b></b></h3>
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<p>While economies in Europe and Japan teeter into and out of recession, the U.S. economy has shown a measure of strength. Many look for a further growth acceleration as 2015 unfolds, including the forecasters at the Federal Reserve, the White House, and the International Monetary Fund (IMF). Such an economic pickup could very well occur. A selection of indicators does indeed point in that direction. At the same time, much in this economy still reflects the growth-retarding influences that have kept this recovery substandard to date. The mix puts probabilities on the side of continued growth to be sure, but perhaps not the acceleration popularly expected at the moment.<sup>1</sup></p>
<p>To put this reality into more concrete terms, this week’s discussion will offer a perspective on various popular economic measures, identifying those that point to acceleration and those that tend to dampen enthusiasm.</p>
<p><b>From the Top Down<br>
</b>The biggest support for optimism grows out of two indicators in particular: a recent acceleration in employment growth and strong readings on gross domestic product during last year’s middle quarters. The Labor Department reports that payrolls have expanded on average by some 282,000 a month during the past six months, far better than earlier in the recovery and almost on a par with past cyclical recoveries.<sup>2</sup> Unemployment has dropped much faster than anyone expected, falling from 6.6% of the workforce in January 2014 to 5.7% this past January. The real economy overall, after a weather-induced annualized drop of 2.1% during the first quarter last year, sprang back at an annualized rate of 4.6% in the second quarter and a still stronger 5.0% rate during the third quarter. The slower 2.6% rate of growth preliminarily reported for the fourth quarter disappointed some, but the picture nonetheless has offered encouragement.<sup>3</sup></p>
<p>As good as this overall picture looks—and it does indeed look good—it requires significant caveats. The second and third quarter surges reflected a catch-up from the artificially depressed first quarter, a point that the fourth quarter slowdown seems to confirm. The average annualized growth for the four quarters came to 2.5%, not much different than other years of this slow recovery. The surge also reflects non-repeatable events. The summer quarter, for instance, saw a 16.0% annualized jump in defense spending.<sup>4</sup> That certainly will not likely persist, even with continued operations against ISIS (Islamic State of Iraq and Syria). On the employment front, the relatively strong gains, especially in the strongest months at the close of 2014, reflected disproportionately high concentrations of hiring in temporary help services and restaurants, while finance, manufacturing, and retail have lagged. Not only does such a relative shift in emphasis explain why average weekly wages failed on average to track the expanding headcount but also it raises questions about the breadth of this recent advance. As if to underscore the chance of a pause or a return to slower growth, the Fed’s measure of industrial production, which had picked up nicely in spring and summer, slowed to a paltry rate of expansion in December 2014 and January 2015.<sup>5</sup> And the Institute of Supply Management (ISM) index of manufacturing activity signaled a slowdown.<sup>6</sup></p>
<p><b>Business Spending and Housing<br>
</b>Part of last year’s growth surge involved a pickup in new business spending on capital equipment and premises. After barely growing at all during first quarter 2014, business spending on new equipment surged at better than an 11.0% annualized rate on average during the second and third quarters. Spending on new structures also surged during this time, at an annualized rate of 8.7%. Things slowed during the year’s final quarter, with equipment spending actually dropping at a 1.9% rate and structures growth slowing to only an annualized 2.6% pace of advance. Apart from what happened in the fourth quarter, there is an additional reason to question the durability of those strong midyear trends. Such surges have occurred before in this recovery and petered out. The early quarters of 2012, for instance, enjoyed an almost 20% annualized jump in spending on new structures, which subsequently turned into a decline. Though continued strong rates of bank lending to business, at a 10.3% annualized pace during the last six months or so, suggests that the 2015 economy may avoid such a relapse, recent declines in new orders for capital goods, at almost a 7.0% annualized rate for the past three months, raises a warning flag.<sup>7</sup></p>
<p>Meanwhile, the housing market continues its notably slow pace of recovery. Sales of new homes have picked up nicely, growing 10.3% during the last six months, but sales of existing homes have shown a less impressive 0.2% rate of advance during this time. New home construction, which had gotten ahead of sales earlier in 2013, has all but ceased growing. Permits for new construction have grown only 1.0% during the past 12 months.<sup>8</sup> Real estate prices have risen on balance, but in a sign that the picture may well remain subdued, December showed a slight 0.2% dip in home prices nationally.<sup>9</sup> One month’s data hardly signal a new adverse trend, but the data do argue against any expectation of an imminent pick up. None of this is surprising, given the increase in mortgage rates and the continued reluctance by financial institutions to lend for residential real estate.&nbsp; According to Fed data, bank lending in the area, after a tentative rise midyear 2014, has again begun to decline.<sup>10</sup></p>
<p><b>The U.S. Consumer<br>
</b>The consumer still is 70% of the U.S. economy, but has played only a muted role in the recent growth surge.&nbsp; Real spending on goods and services has increased an annualized 3.3% during the last three quarters, a pickup to be sure from annualized growth of barely more than 1.0% during first quarter 2014, but otherwise little different from the average growth rate of 2.8% in 2013. The recent pickup in jobs growth does offer a basis for accelerated consumer spending going forward, but perhaps because of the shift in the composition of new jobs, household incomes have shown little acceleration, growing at an annualized pace of 3.7% during the last six months, no faster whatsoever than the prior 12 months.<sup>11</sup> Of course, the slide in energy prices will allow those incomes to buy more, but energy prices would have to keep falling at the same pace to extend any such real spendable income surge, and that is not likely.</p>
<p>Overarching these possibilities is the clear caution that seems to continue to dominate household spending decisions. Whenever spending growth exceeds income growth, households, unlike periods in the more distant past, curtail spending apparently in an effort to keep up savings rates. Thus, when spending shot ahead of income growth late in 2013 and rates of saving, accordingly, fell from 5.2% of aftertax incomes to 4.4%, households subsequently curtailed spending growth to reestablish a savings rate above 5.0% by the middle of 2014. Now that spending has again picked up faster than income growth, consumers may well do the same thing this year and slow the overall pace of economic advance.<sup>12</sup></p>
<p>Retail sales statistics recently gave a tentative sign that just such a pattern may prevail. Despite about a 3.0% boost to real spendable income from the drop in energy prices, these nominal figures actually fell 1.6% this past December and January. To be sure, much of the drop reflected a decline in nominal spending at the gas pump. It took a lot fewer dollars to fill the tank, and dollar (as opposed to gallon) sales at gasoline stations fell 6.5% in December alone. But spending cutbacks were more widespread, with drops recorded in spending on autos, electronics, appliances, clothing, sporting goods, and building materials. It is only one month’s data, of course, but it does offer a sign of continued spending caution among households.<sup>13</sup></p>
<p><b>Pulling the Many Threads Together <br>
</b>This is hardly a depressing picture of the economy. On the contrary, it offers many indicators of relative strength, some of which even support popular expectations of a durable acceleration in the pace of growth. But it does also argue that much of what has kept this recovery slow for the past five years or so remains in place. Whatever the real <i>possibilities</i> of a pickup in the economy’s growth pace, the <i>probabilities</i> still point to a historically subdued rate of recovery. &nbsp;</p>
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Mon, 23 Feb 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/student-debt-grading-the-threat.htmlStudent Debt: Grading the Threat<div class="everything">
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<h3><i>Could widespread defaults on the $1.2 trillion in U.S. student debt cripple the economy? Not likely.&nbsp;</i></h3>
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<p>Student debt problems have received considerable attention of late. The general media have focused on individual hardships and broken dreams. The financial media have focused on how much will likely go unpaid, often referring to the potential for loss as a “bomb.” By noting that student debt is second only to mortgage debt as a line item of household liabilities, much of this financial discussion sensationalizes the problem by drawing an implicit parallel to the mortgage-debt trouble that seemed to have Wall Street on the brink of collapse during the financial crisis of 2008–09. The reality, though far from happy, is less dangerous. Prospective student debt failures are neither large enough nor widespread enough to threaten anything near those troubles of six-plus years ago.</p>
<p>According to the U.S. Treasury, student debt in the United States has indeed exploded, growing more than 300% during the past nine years. It presently stands at about $1.2 trillion. That is not a small figure. A careful parsing of consumer credit categories confirms that student debt is one of the highest costs among household liabilities. The reports indicate that default rates already approach 20%. Debt forgiveness rules promoted by the Obama administration (“forbearance,” in Washington’s way of speaking) will mean that an estimated additional $125 billion, or 10%, of this outstanding amount will also never get repaid, bringing the total expected loss to some $365 billion.<sup>1</sup></p>
<p>Large as this number looks, it needs perspective to gauge potential financial impact. According to the Federal Reserve, all forms of non-mortgage credit in the household sector amounted to $9.4 trillion at the end of the third quarter (the most recent period for which data are available). Mortgage debt outstanding amounts to $13.4 trillion. Potential losses on student loans, then, would amount to 12.8% of all non-mortgage consumer credit, 9.0% of mortgage debt outstanding, and 8.5% of total household liabilities. That is a significant portion of the total, to be sure, but well short of something that could bring down financial markets. Put another way, this student debt figure amounts to a mere 1.5% of the estimated of $81.3 trillion in household net worth and only 1.2% of the estimated of $95.4 trillion in total household assets.<sup>2</sup>&nbsp; &nbsp;&nbsp;</p>
<p>What makes this prospective loss still more manageable is that the federal government holds the bulk of it. In 2010, the federal government took over the student loan business, ceased offering subsidies to private lenders, and lodged the bulk of the outstanding debt with the Department of Education, where it remains. Today, only some 16–17% of outstanding student debt lies in private hands, and that portion is dwindling as these debts are repaid or written off. Any mass failure, then, will fall almost entirely on the taxpayer. And in this context, it matters not whether the debt is forgiven or in default: it amounts to a failure to repay either way. Though this is hardly good news for the taxpayer, it certainly fails to constitute a financial game-changer for the private sector. Nor is the amount overpowering in the context of the federal budget. The potential loss amounts to a mere 10.0% of the $3.7 trillion in total annual federal outlays estimated for 2014 and 14.0% of the $2.6 trillion total annual flow of spending for what Washington refers to as “human resources,” mostly entitlement programs.<sup>3</sup></p>
<p>None of this discussion aims to label prospective student debt losses a welcome event. The individual distress involved is, of course, incalculable. Only slightly more yielding to quantification is the contribution the whole program has made to the inflation of college costs over past years and prospectively. But as the cause of another financial disaster, the matter can only be described as exaggerated.&nbsp;</p>
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Tue, 17 Feb 2015 09:12:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/currencies-what-to-watch-for-after-the-swiss-surprise.htmlCurrencies: What to Watch for after the Swiss Surprise<div class="everything">
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<h3><i>Switzerland’s decision to scrap the franc-euro peg has grabbed the headlines, but the bigger story remains the continued dominance of the U.S. dollar.</i></h3>
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<p>Not too long ago, the Swiss National Bank (SNB) gave up the peg it had maintained for years between its franc and the euro. Market reaction was sudden. Within minutes of the announcement, the franc (or &quot;swissie&quot; as it is called in currency trading circles) rose almost 40% against the euro. Several articles in the financial media described these events as the start of a “currency war.” That is a catchy phrase. It is, however, misplaced. Recent and likely currency moves are much less a matter of targeted war-like policies than they are a reflection of economic and financial fundamentals that have and, for the time being at least, will continue to favor the swissie, and the U.S. dollar, over the euro and most other currencies. The only targeted currency policy was Switzerland’s efforts to keep its franc cheap, and the central bank’s action signals defeat, not the start of a war.&nbsp;</p>
<p><b>The Swiss Story<br>
</b>The story surrounding Switzerland’s action certainly is the most dramatic aspect of the currency picture. It began in 2011, when the eurozone’s ongoing fiscal-financial crisis prompted many to search for a safe haven from the euro. So between late 2009 and August 2011, money flooded into the Swiss franc, raising its value some 25% against the euro. Afraid that this appreciation would hurt Swiss exports and, so, the Swiss economy, the SNB decided to intervene actively in currency markets. By selling francs and buying euros to offset the pricing effects of other inflows, it held the franc rigidly at 1.20 to €1. Since Switzerland can, theoretically, create as many francs as it wishes, the presumption was that the bank could maintain such policies indefinitely.<sup>1</sup>&nbsp; &nbsp;</p>
<p>It is now, however, evident that it could not. The decision to abandon the peg seems to have grown most immediately out of the European Central Bank’s (ECB) turn to quantitative easing. Concerned over the threat of deflation in the eurozone and an intensification of the region’s fiscal-financial crisis, the ECB has earmarked some €1.14 trillion to buy bonds directly on European financial markets. The SNB could see that even a small part of such a flood of euros could overwhelm its sales of francs. The bank also may have abandoned the peg because it feared the inflationary effects of so much money creation and from following the euro down on global currency markets, though the ongoing threat of deflation in the eurozone would make such a prospect distant indeed. As it is, the sharp appreciation in the franc will tend to intensify deflationary pressure in Switzerland.<sup>2</sup></p>
<p>Still, the SNB has not capitulated entirely. To dissuade people from buying its currency, it has driven down short-term interest rates a half-percentage point deeper into negative territory than they already were. Now, a depositor in Swiss francs must <i>pay</i> up to 1.25% interest for the privilege of leaving money in the bank. From the currency’s action recently, these negative rates are hardly discouraging enough to stem the tide seeking a safe haven in Swiss banks and in the franc.<sup>3</sup></p>
<p><b>The Bigger Currency Story &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;<br>
</b>If the tale from Zurich offers the most drama, the larger currency story concerns the rise in the U.S. dollar. Once written off as having lost its supremacy, the dollar has gained markedly during the past six months or so, jumping almost 18% against the euro and almost 12% against the pound sterling. The overall dollar index shows about a 15% rise against a composite of world currencies during this time.<sup> 4</sup></p>
<p>As much as Europe may welcome the euro’s slide as a spur to exports and, hence, economic prospects, these currency moves hardly resulted from targeted policies. Instead, they reflect the more attractive environment offered in the United States for all sorts of investment. U.S. bonds, for instance, offer much more attractive returns. Yields on 10-year U.S. Treasury bonds pay 1.5 percentage points more than German government 10-year yields. Meanwhile, U.S. government finances, though hardly robust by historical standards, still look much less precarious than European finances, where most of the periphery still cannot shoulder their debt obligations without help from the European Union (EU) and the ECB, and where Greece has again brought up the prospect of debt repudiation or rescheduling. Relative economic conditions in the United States are similarly attractive. Recent strong U.S. real gross domestic product (GDP) growth may overstate the economy’s underlying strength, but the United States is definitely growing and considerably more robustly than the eurozone, where the economy can claim only a technical distinction from recession. Though British interest rates, finances, and economics more closely resemble those in the United States than they do the eurozone, its economic ties to the Continent tend to pull sterling along with the euro.<sup> 5</sup></p>
<p><b>Prospects<br>
</b>Since there is little prospect that relative economic and financial conditions will turn about anytime soon, it appears that the U.S. dollar will continue to gain going forward. The latest round of trouble with Greece will only increase European uncertainties and exaggerate the differences favoring the United States. If the U.S. Federal Reserve follows through with its promise to raise interest rates, it will add further to the yield spreads favoring the dollar.</p>
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Mon, 9 Feb 2015 09:57:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/tax-reform-no-hope-for-change.htmlTax Reform: No Hope for Change<div class="everything">
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<h3><i>The latest proposals from the White House all but ensure that no progress will be made on sorely needed tax-code fixes in 2015.&nbsp;</i></h3>
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<p>President Obama has made a bold series of tax and spending proposals. In a reprise of the positions he promoted earlier in his tenure, his latest plans would tax the wealthy and Wall Street in order to spend more on poorer people and the middle class. The Republican-dominated Congress is not likely to embrace such proposals for any number of reasons, but especially because they fly in the face of the sort of reforms that have gathered bipartisan support in the past. Indeed, this push from the White House would seem to all but ensure the failure of reform this year.</p>
<p>The president is looking for a raft of benefits to middle-class and lower-income Americans. These include two years of free community college; a $175 billion tax cut for those in the middle class who pay taxes; legislation to guarantee a week of paid sick leave; larger earned income and child tax credits; and discounted mortgages. The government would pay the $235 billion estimated cost of those benefits, at least that part of the cost that would fall on the budget as opposed to employers and lenders, by raising taxes on the wealthy and on the investment community. The president would, for instance, increase the top tax rate on capital gains, from 23.8% today to 28%, and insist that heirs pay full capital gains when they inherit. He also would impose a fee on the assets of the top 100 financial firms in the country.<sup>1</sup></p>
<p>Republicans, predictably, have criticized the initiative. Senator Orrin Hatch (R-UT), the new Senate’s top tax writer, complained that such measures would penalize “small business, savers, and investors.” He challenged the White House to stop pushing tax hikes and “start working with Congress to fix our broken tax code.”<sup>2</sup> But aside from the usual partisan posturing—from both sides—a more fundamental resistance might reflect the conflict between these new proposals the bases for tax reform entertained by both sides of the aisle and, ironically, also President Obama.</p>
<p>On the personal tax code, the drift of thinking for many years would seek to reduce statutory rates and broaden the tax base by eliminating write-offs and other breaks. Such features dominated the bipartisan Bowles-Simpson plans commissioned by the president in 2010. Those proposals failed less because of this suggestion than because Republicans rejected their tendency to raise taxes overall and Democrats rejected to their imposition of spending restraint. Few objected to the rate cutting and base broadening. These proposals were so popular, in fact, that President Obama resuscitated them in his State of the Union address the following year. Republican-backed budgets proposed by Representative Paul Ryan (R-WI) followed this shared recommendation to reduce rates, broaden the base, and eliminate deductions. Then last year, Representative Dave Camp (R-MI) put forward proposals that also included these basic principles.<sup>3</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>On the corporate code, the consensus for change has been even stronger. At every level of government, there is concern that the current tax code puts U.S.-based firms at a distinct competitive disadvantage in the global economy. The U.S. statutory rate of 35% is now the highest in the developed world. The difference is far from marginal, either. It averages between seven and 11 percentage points above those of other countries. All sides in the debate advocate a reduction in the statutory rate, with the elimination of tax breaks to make up some, all, or more than all of the difference in revenues, depending on how business-friendly the proposer is. The consensus is so strong to reduce the statutory rate that even President Obama and Rep. Camp are close on the matter. The president once proposed a 28% rate, while Rep. Camp sought a 25% rate.<sup>4</sup></p>
<p>The other huge focus of reform is the treatment of overseas earnings. All in Washington seem to agree that the code’s insistence on taxing the worldwide earnings of U.S.-based firms, whenever they earn it, hurts the economy in two ways. Because payment is due on the repatriation, the rule creates a reluctance among U.S.-based firms to bring home their overseas earnings. These monies either accumulate abroad or are reinvested there, neither of which adds to American jobs nor increases the productive power of this economy. The second evil Washington’s tax code breeds is the increasingly popular practice called “inversion,” in which U.S.-based companies find ways to incorporate overseas where they can avoid the U.S. tax code for all but their U.S.-based earnings. Though so far the U.S. Treasury has sought only punitive responses to this corporate practice, even those in government can see it would improve matters to adopt the approach used universally by other developed countries to tax earnings only where they occur.<sup>5</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Much as such measures had gained support over the years, it was never likely that they would pass into law anytime soon. The partisanship within Congress and between Congress and the White House was too intense even before the president’s announcement, and is more so now. Even if the White House were open to the reforms it had previously endorsed, Republicans are reluctant to send the president legislation that could burnish his image, including legislation that suits its longer-term agenda. On the contrary, Republican would much rather send him bills that could embarrass him by forcing a veto. Nor is President Obama, in these last years of his administration, prepared to yield to Congress any more than he did during the past six years, which was precious little. Even if all parties were eager to make progress, tax reform has foundered on details so many times in the past that it could easily do so again in the future. If a new tax code was never likely, it is even less likely now.</p>
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Mon, 2 Feb 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/is-cheap-oil-here-to-stay.htmlIs Cheap Oil Here to Stay?<div class="everything">
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<h3><i>The answer to that question depends on three key factors. Here’s a closer look at each.</i></h3>
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<p>The recent collapse of oil prices raises questions not only about why but also, more significantly, about whether the new low-price regime will last. The answer on oil, as always, requires a look at three component considerations: 1) actual global demand for oil and gas; 2) actual global supply; and 3) anxieties, usually based on geopolitics, about the first and second considerations. Each changes constantly, seldom as forecast, but it is the third, the least stable of the three, that causes the sudden, dramatic price moves, including this recent one. Moderating demand and increasing supplies have played a role in the recent drama, to be sure, but the price decline stems largely from an abatement in geopolitical anxieties, at least as they pertain to oil. Such concerns will, however, likely return, confirming the now well-established historical rule that no oil price regime lasts long.</p>
<p><b>Moderated Demand<br>
</b>The demand part of the picture is the most straightforward. The use of oil and gas, in developed economies especially, has grown at a much slower pace than overall levels of commercial activity (or than was forecast at intervals along the way). To some small extent, this shortfall has its roots in the growth of alternative energy sources—solar, wind, bio-mass, and the like. But for all the political emphasis and investment interest, this area accounts for the least of the change. According to the Energy Information Administration (EIA), alternatives amount to only 9.5% of all energy consumed in the United States. The figure is slightly higher in other developed economies and slightly lower in emerging economics. No doubt, the development of alternatives has kept oil and gas prices lower than they otherwise would have been, but not significantly, and certainly not with the kind of sudden impact that would account for recent dramatic price moves.<sup>1</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Hydrocarbon efficiencies and conservation have played a bigger role. Even in the 1980s and 1990s, when the global economy was increasing at a brisk pace, efficiencies held the growth of global oil demand to a mere 2.0% a year. In the early years of this century, global energy demand accelerated, largely because emerging economies became a larger part of the picture, and they have neither the infrastructure nor the wealth to apply the efficiencies that had become commonplace in the United States, Japan, and Europe. Still, the application of efficiencies continued. The United States today, for instance, produces a dollar of gross domestic product (GDP) with less than half the oil and gas it required 20–30 years ago.<sup>2</sup>&nbsp; &nbsp;</p>
<p>While there can be no doubt that these efficiency gains in North America and elsewhere have made room for recent price declines, the poor performance of the world economy has had a more immediate demand effect. Japan, after a brief surge, has fallen into recession. Europe, under the weight of its fiscal-financial crisis, also has performed poorly. From a technical standpoint, the eurozone may have avoided the recession designation, but only technicalities have distinguished its economic performance from recession. China is growing at much slower pace than previously; while its economy expanded in real terms at 10–12% a year not too long ago, it now struggles to sustain a 6% real growth rate. Other emerging economies, including India, have slowed along similar lines. The U.S. economy has accelerated of late, but it is far from apparent that the new, more rapid growth pace is sustainable.<sup>3</sup></p>
<p><b>Rising Supply<br>
</b>More than slowed demand, a surge in global oil and gas supplies has made still more room for price declines. On this point, fracking is the star of the show. This technology has increased U.S. oil and gas production by more than half during the past five years. The surge has added fully 4.0% to global oil flows since 2009, a not insignificant difference. In addition, technological advances also have enabled Canada to access its tar sands deposits more cost effectively than in the past. That country has increased its overall production by more than a third during this time, adding another 1.2% to overall global output. Meanwhile, other new technologies have allowed producers to extract more oil and gas from existing conventional wells, enabling production in some places to pick up even in the absence of new finds.<sup>4</sup></p>
<p>Beyond such tangible gains, prospective new sources also have factored into future supply assessments and, accordingly, into prices. Playing a large role in this part of the story is a major South Atlantic find made by Petrobras, the Brazilian oil company. This Lula field (as it is called) has the potential to add the equivalent of 6.5 billion barrels to known global oil and gas reserves, 13 billion barrels when combined with other new Brazilian fields. When fully developed, these sources should pump the equivalent of 4 million barrels of oil a day onto world markets, a 5.2% addition to current global flows. More recently, Australia has announced a shale find that its engineers estimate could increase known global reserves by 12%. The find is too new yet to yield estimates of production flows. Preliminary Exxon drilling in Russia’s arctic region had reported good prospects, though such activity has all but stopped because of the economic sanctions imposed on Russia. Potentials also have gained from the possibility that new but conventional extraction technologies will spread from North America to other parts of the world. Engineers estimate that Russia could increase production by 50% in this way, even in the absence of any new finds.<sup>5</sup></p>
<p>Nor will the price declines reduce new North American flows anytime soon. The concern on this front stems from the perception that fracking and tar-sands extraction cost more than pumping from conventional wells. To be sure, if prices stay low for an extended time, pumping from these sources might well slow at the margins. But the fact is that tar sands and shale production are not as fragile as some suggest. Production costs can indeed sometimes run high. In some parts of a fracking field, it could cost $90 a barrel to lift oil. But other spots in the same field might cost only $20 to lift the oil. The crucial point is that developers contract for whole fields and for relatively long times. They will, as a consequence, continue to work them entirely for the foreseeable future. On average, as engineers suggest, tar sands and shale are largely profitable as long as oil remains above $50 a barrel—and prices would have to remain below that level for quite some time to have a significant impact on production flows.<sup>6</sup></p>
<p><b>Anxieties Rise, Then Fall<br>
</b>This basic supply-demand picture suggests about $60 a barrel as a fundamental market-clearing price, the level that equates fundamental supply and basic demand for oil and gas, all else equal. Such a condition has, however, prevailed for some time. Though it has made room for the sudden price drop of the last few months, it certainly cannot account for it. After all, these underlying supply-demand conditions prevailed last spring, when prices topped $100 a barrel. An explanation of that seemingly high anomaly and the more recent, sudden price drop requires a consideration of the third, more volatile pricing influence: the largely geopolitically based anxieties over supply and demand.</p>
<p>These looked very different only six months ago, when oil prices were uncomfortably high. Russia then had just moved on the Crimea and eastern Ukraine. Many voiced concerns about what the Kremlin would do with oil shipments in response to Ukrainian resistance and Western economic sanctions. At the same time, the military advances by ISIS (Islamic State of Iraq and Syria) in Iraq and Syria were at flood stage. Concerns prevailed about what would happen in the then-considered likely event that ISIS gained control over much or all of Iraq’s oil. Initial ambiguities about Washington’s response to ISIS added to the general anxieties. At the same time, doubts about the course of negotiations over Iran’s nuclear program raised fears that tensions in the Persian Gulf would intensify. Though production gains in the United States, Canada, and elsewhere had given long-term hope that global supply would diversify away from these less-than-reliable regions, the unmistakable fact was, and remains, that the Persian Gulf and Russia account for almost 44% of global oil and gas output. That fact and this mélange of anxieties understandably prompted markets to bid a considerable risk premium into the price of oil, more than $40 a barrel above the $60 basic supply-demand benchmark at its peak.</p>
<p>The intervening months, however, have seen much of this anxiety dissipate. Washington’s position on ISIS now is clearer than it was. These radical jihadists have suffered military reverses, quelling former fears about them gaining control of Iraq’s oil. What is more, it has become clear in the interim that ISIS happily sells what oil it has, raising confidence that the oil would find its way to market even if ISIS captured all of Iraq’s oil. Also, since prices peaked, Iran and the West cordially have agreed to differ on a nuclear deal, easing oil supply, if not nuclear proliferation, anxieties. And it has become increasingly apparent that Russia is too oil dependent to use it as a weapon, at least not as readily as many feared last spring. The risk premium, accordingly, has collapsed.</p>
<p><b>Technical Influences and Likelihoods<br>
</b>In this turmoil, technical factors have brought prices below the $60 benchmark associated with underlying supply and demand. A part of this is simply market momentum. When the prices of any asset make as sudden a move as oil has, traders tend to place buy and sell orders to position themselves for a continuation of the trend, and these alone can actually extend the trend, at least for a time. The low prices also have had an economically perverse effect on production. Instead of inducing production cuts (as the textbooks say they should), Iran and Russia in particular have done the reverse. It seems they are so dependent on oil sales for income that they have stepped up production to make up for lower prices. Their behavior stands to reason. Some 80% of Russia’s export revenue comes from oil, and the Kremlin depends on oil for 50% of its revenues. Figures on Iran are not substantively different. Very little current data exist on its actions, but oil traders provide considerable anecdotal support that these countries have increased sales. Meanwhile, Saudi Arabia, eager to increase the economic pressure on Iran especially, refuses to cut back on its production, as it might have done to stabilize prices in the past. The subsequent oil glut has increased inventories and created an acute, immediate additional downward price pressure.<sup>7</sup></p>
<p>This kind of movement can carry on for a while, and might even push prices down further. Eventually, the market will clear its excesses and, in the absence of some shock, return prices to the $60 level that reflects underlying supply and demand. But this tidy calculation comes with a warning: It can happen only in the absence of shocks—and shocks, in fact, are likely. The recent dissipation in geopolitical anxieties is far from durable. Moreover, neither Russia nor the Persian Gulf is a predictable or reliable place. Russian president Vladimir Putin is a desperate man. Spillovers from Syria’s wars, gains by ISIS, renewed animosity between Iran and the West, and a long list of less definable, troubling events in the Middle East could easily raise anxieties again and force oil markets to re-impose a significant risk premium on prices. Today’s new low price is far from secure, much less a new normal, as some have suggested. Any number of headlines could drive prices back above $100 a barrel very quickly, even more rapidly than they have fallen. &nbsp;</p>
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Mon, 26 Jan 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/setting-the-scene-for-2015-video.htmlVideo: Setting the Scene for 2015<div class="everything">
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<h3>What can investors expect from the Federal Reserve, the economy, and financial markets in 2015?</h3>
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Wed, 21 Jan 2015 11:42:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/greece-perilous-odyssey.htmlGreece's Perilous Odyssey<div class="everything">
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<h3><i>At best, the black sheep of the eurozone family is a troubling source of uncertainty for policymakers and global markets—at worst, it’s a potential disaster.</i></h3>
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<p>Greeks will go to the polls on January 25. The outcome may lead to debt repudiation, other severe losses on assets, and the beginning of the end of the common currency. Even if Europe avoids the worst, the best anyone can hope for is heightened levels of uncertainty. It is not a pretty picture, and the blame for this mess is so widespread that it would take a book just to name the people and institutions responsible.</p>
<p><b>The Story So Far<br>
</b>Greece has for some time occupied the epicenter of Europe’s troubles. It was, after all, Athens that in 2009 triggered the Continent’s still-raging fiscal-financial crisis by admitting that it had misled about its financial health. Since then, Greece has received two European Union (EU) bailouts, totaling €240 billion, each conditioned on budget austerity and other economic reforms pressed by the EU, the European Central Bank (ECB), and the International Monetary Fund (IMF), the so-called troika. These reforms included measures to privatize government assets and steps to make the economy more dynamic and competitive through labor market and regulatory reforms. Greece has stuck to its promised budget austerity, though not without considerable angst and political close calls. Though troika monitors remain disappointed about other reform efforts, they had pretty much concluded that Athens had come far enough to emerge from bailout strictures. The country’s budget had balanced, they noted, and the economy was beginning to grow, albeit haltingly and from a deep recession.<sup>1</sup></p>
<p>But crisis has found Greece again. This latest phase arises from a quirk in Greece’s political process. The largely ceremonial position of president is vacant. Prime Minister Antonis Samaras of the new Democracy party—center-right, pro-austerity, pro-cooperation with the troika—put forward Stavros Dimas for the post. Normally, this would have been a political non-event. Dimas ran unopposed. But the left-leaning, anti-austerity Syriza party, then leading in the polls, realized that a failure to get sufficient votes would trigger a general election. It worked with other opposition parties, including the far-right and actively anti-Europe Golden Dawn party, to vote down Dimas. Prime Minister Samaras had to call an election. Perhaps because Syriza’s lead in the polls had by then narrowed, he decided on an earlier rather than a later date. Now this quirk has raised the chance of an anti-austerity coalition coming into power in Athens and with it possibly an end to Greek cooperation with the troika, even an end to Greek membership in the common currency.<sup>2</sup>&nbsp; &nbsp;</p>
<p><b>Uncertainties Inside Uncertainties<br>
</b>It is entirely possible that Samaras will return to office. Syriza’s lead has already shrunk from double-digits not too long ago to only three percentage points, according to some polls, well within their statistical margin of error. But even with a Samaras victory, uncertainties would remain. No doubt chastened by his defeat in the presidential poll and by the need to have called an election, he could easily show a greater willingness to soften austerity policies and delay other reforms still longer. Europe in time might find him and his new coalition much less cooperative than he or it once were. And this is the most stable and predictable of the potential environments that could emerge from the Greek vote.<sup>3</sup>&nbsp; &nbsp;&nbsp;</p>
<p>A Syriza victory, with its volatile leader, Alexis Tsipras, as prime minister, would open a myriad of possibilities, one more destabilizing than the other. Actually, there is no way to know what sort of agenda he might put in place. He has over the last couple of years talked out of so many sides of his mouth that Greeks going to the polls later this month really cannot know for what or against what they are voting. When Syriza first gained popularity, Tsipras expressed unrestrained hostility to Greece’s membership in the euro and argued that Athens should repudiate much of its debt. More recently, he has softened his resistance to euro membership, though he still espouses a determination to tear up the austerity conditions imposed by the troika. His current position on debt repudiation remains ambiguous. All this could, of course, change again after a newly elected Prime Minister Tsipras had time to meet with German chancellor Angela Merkel, ECB president Mario Draghi, and the IMF.<sup>4</sup>&nbsp; &nbsp; &nbsp;</p>
<p>Against such a backdrop, the election promises anything from an ambiguous moderation in Greece’s playbook all the way to an exit from the common currency, what journalists in the early days of the current crisis referred to as “Grexit.” It is little wonder, then, that markets quickly upped the interest rate charged on Greek borrowing, from about 5.5% a few weeks ago to 9.5% right after the election was called.<sup>5</sup></p>
<p><b>Possibilities—Some Helpful, Most Destructive &nbsp; &nbsp; &nbsp;&nbsp;<br>
</b>For the Greeks, these more extreme possibilities could cut two ways. On the positive side, an exit from the euro and a return to a depreciated drachma would aid growth by making Greek goods and services cheaper to the rest of the world and, accordingly, more competitive. Debtors within Greece would benefit, too, having the ability to discharge their obligations in a currency much depreciated against the euro. On the negative side, such a prospect would destroy wealth. Greek savers would see the global purchasing power of their assets drop with a drachma depreciation, whatever initial conversion rate the government determined.</p>
<p>For those holding the outstanding overhang of euro-denominated Greek debt, the matter could get even more complex. An outright repudiation would, of course, bring complete losses to lenders, most directly to banks elsewhere in Europe and indirectly to anyone who holds equity in or the debt obligations of these European banks. That would include many American financial institutions and investors. A rescheduling of the debt, perhaps by lengthening maturities or arbitrarily reducing the stated interest payments, would cause less drastic immediate losses, but losses nonetheless. These hardships would occur whether Greece stayed in the euro or exited, though it is an open question whether the rest of the eurozone would allow Greece to remain in the common currency after repudiating its debt or unilaterally rescheduling it.</p>
<p>An exit from the euro would add still more complications. Greece could return to the drachma and still honor its euro debt, though the government would face a great burden in doing so, since it would take a lot of depreciated drachmas to meet those euro obligations. It is possible, if not especially likely, that Greece could exit the euro and insist on rescheduling the outstanding debt in drachma, imposing a huge loss on lenders, though not as much as with outright repudiation. No doubt such a move would create international lawsuits and take years to resolve. In any of these possibilities, Greece would find it much more difficult and expensive to borrow on international financial markets, especially with a return to the drachma, for then lenders would insist on a special premium to protect them against possible future currency losses, certainly a greater premium than they would demand with euro-denominated debt.</p>
<p>In one respect, Greece can matter only little to Europe or the eurozone. It is too small to threaten the basics of either European economics or finance. Its gross domestic product (GDP), at the equivalent of $243 billion in 2013, is not even a fifth the size of Spain’s, only slightly more than one-tenth the size of Italy’s, and barely more than one-twentieth the size of Germany’s economy. Greece’s outstanding debts amount to only 1.0% of all European bank assets. It would not be a happy day if those Greek assets were to become worthless, but it would hardly become the stuff of a financial catastrophe. The financial system would remain no less sound than it is presently, and Europe’s economy might even look marginally stronger with Greece gone.<sup>6</sup></p>
<p>But in another respect, a Greek exit or debt rescheduling could have serious ramifications by pointing up alternatives for other beleaguered members of Europe’s periphery. Any debt repudiation, with or without an exit from the common currency, could tempt other heavily indebted nations to fellow suit, entirely or partially, as a way to ease their immediate burdens. Even if Greece were to take no more drastic a step than to renegotiate the austerity strictures of its bailout, others might ask for similar concessions. Granting them would undermine EU efforts at control and delay the continent’s return to overall financial health. It also could erode critical German support by putting the lie to the promises Berlin gave to convince German taxpayers to bankroll the bailout. And if Athens were to withdraw from the euro, questions about the ultimate viability of the common currency would grow, complicating any efforts at financial healing and making it that much more difficult to hold this experiment together.&nbsp;</p>
<p><b>Likelihoods &nbsp; &nbsp;<br>
</b>To assess which of these directions is likely, however, is clearly impossible at this juncture. What is clear, though, is that for the foreseeable future, Europe will labor under more uncertainty than previously, and with three prospects: 1) Greece will continue for some time to pay considerably higher borrowing rates than it did just a few weeks ago, which could in time undermine some of the budget gains the country has made even if in the interim Athens holds to its austerity promises; 2) to the extent that Greek intransigence grows, fears over a general turn in this direction elsewhere in Europe’s periphery will tend to raise borrowing costs there, even if these governments make no overt statements or actions to step away from austerity; and 3) prospects for the eurozone will remain ever more doubtful than in the past, weighing further on the euro’s value and making it still more difficult than it already is for the zone’s leadership, particularly at the ECB, to plan or otherwise conduct its business effectively. &nbsp;</p>
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Tue, 20 Jan 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/central-banks-power-shortage.htmlCentral Banks' Power Shortage<div class="everything">
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<h3><i>The Federal Reserve and the European Central Bank face significant limitations on what they can do to solve economic problems.</i><b></b></h3>
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<p>Pity the central bankers. The media from time to time may characterize them as the all-powerful shapers of economic destiny, but in reality they have only the bluntest of policy tools at their disposal, can seldom accomplish much on their own, and, when they do act on their own, they often find themselves beset by unintended consequences. All these limitations and the attendant risks have become increasingly apparent as the U.S. Federal Reserve and the European Central Bank (ECB) continue to deal almost single-handedly with their respective financial-economic crises.</p>
<p><b>Facing Many Constraints<br>
</b>The root of the bankers’ problem is straightforward enough: they cannot deal directly with the underlying causes of the crises they are called on to manage. The American crisis, for instance, started with a real estate collapse and evolved into severe federal budget problems in an extremely sluggish recovery. The Fed has done what it could to ease the attendant strains. By increasing flows of liquidity, it has made credit in general more available, decreased its cost, and, by so reducing the threat of defaults, prevented panic from spreading to otherwise healthy sectors. But for all the relief provided in this way, none of the Fed’s actions have diminished the debt overhang or promised more effective budget control. Only the government and private players can do that. Europe, similarly, has faced a debt overhang from misguided budget policies. The ECB also has used a flood of liquidity to ease immediate strains and stop a contagion in markets. But it, too, has had to wait on others—in this case, the governments of Europe’s so-called periphery—to remedy the underlying problems. The most, then, the central banks have done, or could do, is buy time for others to address the causes of crisis. &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Central bankers face still other constraints. They know well that they cannot buy time indefinitely. The longer they maintain extraordinary flows of liquidity, the more they increase the risk of other problems. One is financial bubbles. Some suggest that a bubble has already formed in U.S. Treasury and German government debt. Were these or any other bubble to burst, Europe or America would find itself involved in a new financial-economic crisis. The extra liquidity flows also impose longer-term risks of an increase in inflationary pressure, with all its attendant evils. Yet because central banks cannot simply withdraw the liquidity support without risking financial upheaval and recession, at least not until those who can implement fundamental solutions do so, they face what only can be described as a Hobson’s choice (that is, a choice, or not, of only one option), whereby every day they must deal with pressures both to increase and decrease liquidity in markets. &nbsp;&nbsp;</p>
<p><b>Two Strategies<br>
</b>Policymakers at the Fed seem at the moment to have decided to split the difference between the two extremes. As sufficiently worried as they are about the longer-term dangers of excess liquidity, Fed policymakers have ended their former practice of buying government and mortgage debt outright—a tactic referred to as quantitative easing. They plan to curtail amounts of liquidity further sometime in 2015 by raising interest rates.<sup>1</sup>&nbsp;But because they still have no fundamental remedy for the underlying problems, monetary policymakers remain especially concerned about moving too far or too fast. Fed chairperson Janet Yellen has acknowledged this precarious balancing act by making clear the Fed’s willingness to postpone or soften any part of its planned policy change. Such a halfway approach hardly gives confidence on either side, but, in the circumstance, this is the best the Fed can offer.</p>
<p>The ECB is in an even tighter spot. Like the Fed, it worries about financial bubbles and, in the fullness of time, even inflation. But the greater severity of its debt crisis makes it harder still to think about ending extraordinary liquidity flows. The decision by Europe’s periphery to adopt only half the suggested remedies has intensified the pressure on the bank.<sup>2</sup>&nbsp;Germany, the ECB, and the European Union (EU) have stressed correctives that include both budget control—in order to maintain credibility in capital markets and avoid a relapse into crisis—and steps to make these economies more flexible and growth oriented—in order to produce sufficient new wealth to overcome the otherwise ill effects of austerity and ultimately discharge the debt overhang decisively. Because these governments have opted only for the budget control and not the economic reform, strong recessionary pressures have developed and even the threat of near-term deflation, both of which have compounded the financial crisis and postponed indefinitely the time when the ECB can consider efforts to forestall any of the ill effects of strong liquidity flows.&nbsp;</p>
<p><b>Future Pressure &nbsp; &nbsp; &nbsp; &nbsp;<br>
</b>It is a frightening and increasingly unstable picture. One Wall Street veteran has characterized it and the central bankers in an especially cruel way: “They may not know what they are doing,” he has said, “but they are afraid to stop.”<sup>3</sup> There is an element of truth here, but it nonetheless overstates. The central bankers do know what they are doing. They are just stuck because others—those with the power to fix matters—either cannot or will not step up to their obligations. The Fed may succeed with its cautious unwinding, even if Washington fails to remedy its budget and economic policy problems. The ECB, however, can entertain no such hope. Circumstances compel it to maintain extraordinary flows of liquidity, whatever its legitimate fears about the dangers involved.</p>
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Mon, 12 Jan 2015 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-municipal-finances-on-the-mend.htmlU.S. Municipal Finances On the Mend<div class="everything">
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<h3>While much work still needs to be done, the financial condition of state and local governments in the United States continues to improve. What does this mean for investors?</h3>
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<p>State and local governments in the United States continue to improve their finances. They are, of course, a long way from financial health, though some are further along that road than others. It will take years, perhaps decades, maybe longer before investors can declare this sector financially sound in any conventional sense of that phrase. But there is improvement nonetheless, despite some inflammatory and misleading headlines, and that should relieve many of the fears people have about investing in the sector.&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>These governments have improved matters in the same basic way that anyone would dig out of a financial hole. Though their revenues have grown only slowly, largely because of the substandard pace of the economy’s recovery, they have nonetheless kept outlays growth to an even slower pace. Thus, between 2010 and 2013, total receipts in the state and local sector of the U.S. economy grew at only a 2.1% annual rate, but these governments kept spending growth to an even slower 1.6% average annual rate. (All government finance data presented herein are from the U.S. Federal Reserve.) Mostly they accomplished this through severe restraint on discretionary spending, which only grew at a 1.4% annual pace. This more than offset the 2.6% growth pace of outlays for social benefits.</p>
<p>The figures are larger for the most recent four quarters, but these governments have nonetheless stuck to the same program. An 11.1% surge in transfers from the federal government pushed up receipts 4.4% during this recent time. To be sure, these governments succumbed to the temptation to spend much of this extraordinary flow. They pushed up social benefits payments 10.6%. But because they only increased their discretionary outlays 2.4% during this time, overall outlays still grew at a slower pace than receipts.</p>
<p>These efforts have allowed state and local governments to improve their net savings flows impressively. After accounting for depreciation, these, according to Federal Reserve statistics, averaged an annualized $91.4 billion during the third quarter this year, the most recent period for which data are available. Though this figure is a still only a modest 4.1% of total revenue, it is nonetheless a 75.1% improvement over the $52.2 billion in net savings averaged in 2010. What is perhaps even more encouraging is that the current rate of net savings from revenues is almost 60% above the 2010 rate.</p>
<p>Such improvements, though modest by many standards, have enabled state and local governments to improve their balance sheets. Between 2010, for instance, and the third quarter this year, the most recent period for which data are available, they have increased their holdings of financial assets 4.2% and cut their total liabilities of every kind almost a full percent. They have also cut back on their reliance on debt. Between 2010 and this year’s summer quarter, the outstanding volume of municipal debt of any kind had dropped almost 4.5% or by just under $132 billion. The outstanding amount of long-term municipal debt had fallen 3.6% or $105 billion, while the amount of short-term debt used by these governments has dropped by more than half. Short-term debt today constitutes only 1.3% of all municipal debt outstanding, down from 2.1% in 2010.</p>
<p>All this improvement, though welcome, is modest compared to the needs of state and local financing that became so apparent in 2009. Still, the picture of improvement should relieve investors of their worst fears concerning this area, if not in every particular, then in general. Meanwhile, the decreasing volume of debt, both the new flows and outstanding amounts, should further enhance the attractiveness of such holdings, especially since U.S. municipal yields, at just about every maturity and credit rating, still stand near historic highs next to U.S. Treasury and corporate debt.</p>
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Mon, 5 Jan 2015 09:30:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-consumers-spend-more-bah-humbug.htmlU.S. Consumers: Spend More? Bah, Humbug<div class="everything">
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<h3>Despite an improving labor market and lower oil prices, consumer outlays should continue to expand at a slow pace. Here’s why.</h3>
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<p>Sometimes, something says something good about the economy’s growth prospects. Two quarters of relatively strong advances in real gross domestic product (GDP) and more recently falling oil prices and strong November jobs numbers offer such signs. They are welcome. Still, reason remains to curb levels of enthusiasm. The employment figures have given plenty of false signals in the past, and many of the same forces dampening growth so far in this recovery remain in place. Especially for the consumer, fully 70% of the economy, seems unwilling to act as aggressively as in the past and so is less likely to propel the overall pace of growth.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>The most recent good news is a pickup in the pace of hiring. Recent reports for November indicate 321,000 new jobs created during the month and upward revisions in previous months’ estimates.<sup>1</sup> While this is indeed news, it is important to keep in mind that individual months in the past have shown surges that have then petered out. In January 2012, for instance, payrolls rose by 360,000 only to slow to a disappointing 96,000 by April. What is more important, and as a consequence more encouraging, is the general improvement this year over 2013. Every month this year, except weather–depressed January, has reported payroll increases over 200,000. Only five months showed such gains in 2013 and a still smaller portion in 2012. The 2.0% growth in payrolls so far this year compares to only 1.7% in 2013 and a 1.6% yearly rate averaged between 2010 and 2012. The jobs picture still has many troubling weak spots, but the trend is encouraging.<b><i></i></b></p>
<p>Presumably, the additional jobs will increase household incomes, encourage more consumer spending, and so accelerate the pace of overall economic growth. If the percentage point increase in employment were to translate directly into income, it would raise wages and salaries growth from the 4.3% pace averaged during the last twelve months toward 5.1%. Since wages and salaries constitute about half of all income in this economy, overall income flows would accordingly rise from the 3.9% recorded during the past twelve months toward 4.6%. With taxes still rising as a percent of gross income, spendable income growth would then register about a 4.5% nominal annual rate of increase. And if households were then to spend the increase, the overall pace of nominal consumer spending would accelerate from the 3.9% rate averaged during the past twelve months to about 4.5%, or about 3.0% in real terms. That would accelerate the economy’s overall 2.3% rate of real growth averaged during the past four quarters up to about 2.8%, an improvement but still short of the economy’s long-term average growth rate of 3.2% and its average growth rate of closer to 3.8%.<sup>2</sup>&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>But these are big “ifs.” For one, it is not apparent that the recent accelerated pace of employment growth can persist. False starts in the past issue a warning, and all the factors that so far have kept back hiring remain in place. Managements certainly continue to carry scars from the great recession that temper their impulse to expand, what the great economist John Maynard Keynes referred to as their “animal spirits.” Continued uncertainty about costs and the ultimate requirements of the Affordable Care Act and even the Dodd-Frank financial reform legislation will continue to reinforce such hesitations. Meanwhile, households, too, have shown an atypical caution about spending. Compared to past recoveries and the past in general, they have spent less aggressively in this recovery and saved more. On average, households have saved well over 5.0% of their after-tax income in this cycle, low by international standards but high by past American standards. What is more impressive, and indicative of how they will likely behave going forward, is how households, whenever their savings rates have fallen below trend, have quickly corrected by slowing their rate of spending.&nbsp;&nbsp;&nbsp;</p>
<p>On balance, then, the consumer should hold to a comparatively slow rate of expansion even if the improved hiring trend is durable. It should come in below a 3.0% yearly rate. The current quarter may prove an exception, however. The recent precipitous drop in oil and gasoline prices will leave the consumer at least temporarily better off. Because energy absorbs almost 10% of the average household budget, the recent drop in price amounts to about a 2.5%&nbsp; jump in real spendable income, a good portion of which consumers will no doubt use to improve the holidays, making the fourth-quarter GDP look better than the fundamentals and longer-term prospects described above. But unless the oil price declines go deeper still (not especially likely), much less if oil prices bounce back up (entirely possible given the volatility in the Middle East), the pace of consumption growth and overall growth in the new year should continue at a still substandard rate.</p>
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<p><span class="legal"><sup>1</sup> Employment data from the U.S. Department of Labor<br>
<sup>2</sup> Data from the U.S. Department of Commerce</span></p>
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Mon, 29 Dec 2014 09:23:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/setting-the-scene-for-2015.htmlSetting the Scene for 2015<div class="everything">
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<h3><i>What can investors expect from the Federal Reserve, the economy, and financial markets in the new year?</i></h3>
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<p>Market prospects in the coming year would seem to hinge on four major considerations. One is geopolitics, inherently unpredictable but potentially disruptive, especially these days. Another is the Federal Reserve’s plan to raise interest rates along a gentle path beginning sometime in the middle of the year. Third is the perennial question of where value lies within and between markets. Fourth is the state of the U.S. economy. The balance of probabilities on these four fronts favors two broad investment positions. In fixed-income investing, it would seem best to lean away from longer-duration quality bonds in favor of shorter-duration instruments and more credit-sensitive issues, including municipals. Though equity valuations are not what they were, they remain attractive enough to sustain the rally, especially since the economy and, consequently, earnings are likely to continue growing.</p>
<p><b>A Word on Geopolitics<br>
</b>No investor can contemplate possibilities without acknowledging the risk of geopolitical disruptions. An advance by ISIS (Islamic State of Iraq and Syria) or increased Iranian tensions could easily reverse the oil price relief that most global economies presently enjoy. Korean tensions or a more assertive level of Chinese activity in the East or South China seas could, at the very least, shift Washington’s budget priorities and more seriously threaten a shooting war, either of which would change investment calculations. Another turn in what has been called the Arab Spring could impose vaguer risks on the investment horizon and certainly change relative pricing. More weakening in Japan’s or Europe’s economy or dangerous deflationary effects also could alter investment calculations, pricing, and impose the need for portfolio adjustments. And this is only a partial list.</p>
<p>But investors cannot configure portfolios to guard against, much less take advantage of, all these factors. It is not even possible to assign probabilities to such risks. In this respect, the array of such possibilities, though easy to itemize and identify, are much like the almost equal possibility of disruption from entirely unforeseen events. Rather than twist portfolios within what is tantamount to a random range of possibilities, it would be better to remain alert and nimble to such concerns, while otherwise structure investments around the economic and financial fundamentals, where, however obscure the future, there is a greater ability to discern likelihoods and set probabilities.</p>
<p><b>Fixed Income &nbsp;&nbsp;<br>
</b>For the moment, extremely low interest rates and yields in Europe and Japan, along with the economic woes besetting these regions, are driving money into U.S. fixed-income markets. These flows have kept Treasury and agency yields low as well as yields on high-quality corporate bonds.<sup>1</sup> But unless the eurozone and Japan truly fall apart, these influences can only last so long. Looking out beyond the next few weeks and months, then, the big bond consideration is the Fed’s clear desire to raise interest rates—“normalize” them, in the words of Fed chairperson Janet Yellen.<sup>2</sup></p>
<p>On one side, it would be easy to exaggerate the danger here. References frequently made to the financial havoc created by Fed rate hikes in 1994 are misplaced. Chairperson Yellen as well as various regional Fed presidents have made clear their intention to exercise caution and move rates up, once they start, along a very gradual path. Yellen has further stressed the Fed’s ongoing sensitivity to statistics—meaning that it has no desire to raise rates far enough or fast enough to jeopardize economic growth. Yellen also has indicated that the Fed will not even begin to raise rates until it is confident that the economic recovery can withstand such a move.<sup>3</sup>&nbsp;Taking the Fed at its word, then, investors have little or no reason to worry over an economic stall, much less a decline, over this time period. (More on the economy below.) &nbsp;&nbsp;</p>
<p>Still, if the Fed will surely go gently, its direction is clear. Investors can then be reasonably sure that bond yields will follow short-term rates upward or even anticipate the Fed’s moves as the start date for such increases becomes more certain. This prospect threatens returns in intermediate- and longer-term fixed-income instruments, especially those in Treasuries, agencies, and high-grade corporate paper, which respond to little else but general rate movements. In longer maturities, there is a good prospect of capital losses here sometime during the course of 2015. Since in the interim such assets pay a relatively paltry yield, this class of investments hardly offers much appeal. There are, however, fixed-income avenues that offer better opportunities or at the very least better defense.&nbsp;</p>
<p>One clear defense against rising yields is to shorten the average duration of a portfolio’s fixed-income holdings. Though a rise in short-term interest rates would hit the capital values of intermediate-term and even shorter-term instruments, longer-term instruments are much more vulnerable. Even if the basis-point change in longer yields is considerably lower than on shorter- and intermediate-term instruments, the price leverage on the longer-term instruments is disproportionally greater. &nbsp; &nbsp;</p>
<p>A second option would be to reach for more credit-sensitive instruments, where yield spreads offer protection of a sort. Though corporate junk bonds, for instance, carry yield spreads over Treasuries that are slightly lower than they have averaged for the last 40 years or so, these spreads remain wide, considering how default rates among corporate bonds have declined. It seems likely, then, that shrinking spreads on credit-sensitive instruments will absorb much of the prospective rate increases, protecting those who hold such instruments from the capital losses more likely in higher-quality instruments. Adding to their appeal, credit-sensitive instruments also pay holders a much more generous yield. An especially cautious investor might combine these two defenses into a third that shortens duration with more credit-sensitive instruments.<sup>4</sup></p>
<p>A fourth option is municipal bonds. These, of course, are suitable only for tax-paying investors; but even at low marginal tax rates, municipal bonds provide attractive aftertax yields, much more attractive than they have been historically. Indeed, even relatively high-grade municipals pay higher aftertax yields than do corporate junk bonds. The root of such value is clear in the headlines about Detroit and Puerto Rico. But despite such notoriety, default rates among municipal bonds are very low, less than one-tenth of one percent in fact, and, more important, lower than on corporate bonds. On this basis, such bonds hold out the promise of absorbing in shrinking spreads much of the yield increases likely in Treasuries, agencies, and high-grade corporate paper, while at the same time paying investors comparatively attractive aftertax yields.<sup>5</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Equities and Economics &nbsp;&nbsp;<br>
</b>In contrast to the complexities facing fixed-income investing, the prospect for a continuation of the equity rally has two things going for it: 1) value remains, even if it is not as overpowering as it was one, two or three years ago, and 2) the economic recovery, though likely to remain substandard next to history, will continue to promote some earnings growth, if not the striking gains exhibited earlier in the recovery.</p>
<p>The market still offers value. The S&amp;P 500<sup>®</sup> Index,<sup>6</sup> for instance, offers a price-to-earnings multiple about where it has averaged for the last 35–40 years. On that basis, even a cautious view of the market would label it fairly valued, able, at the very least, then, to follow earnings. With nominal domestic revenues likely to expand about 4.0% in the coming year, gross earnings, with modest help from continued operating leverage, look likely to come in at close to 5.0%. Net share buybacks should put the per-share earnings gain at 6.0%. Without any expansion in multiples, stock prices could track this earnings growth and so put in a similar 6.0% gain. Since on top of such price gains stocks also offer a dividend yield of about 2.0%, a conservative expectation would put equity gains at about 8.0%—not the impressive figures of past years, to be sure, but respectable nonetheless.<sup>7</sup></p>
<p>Prospects improve when viewing equity valuations relative to bonds or cash. On these bases, stocks offer better than fair value; in fact, they look cheap. There are, of course, a host of metrics for such comparisons. There is no space here to go through all of them, but since they all agree, there is no need to do so either. The most straightforward comparison of dividend yields with rates on cash can illustrate. As already indicated, the S&amp;P 500 pays a dividend yield of about 2.0%. Deposit rates vary, but generally pay about 25 basis points (bps), some 175 bps <i>less </i>than stocks. Historically, cash pays 200 bps on average <i>more</i> than dividend yields, not less, as is the case now. Such measures, and others of greater complexity and greater obscurity, speak not just to still attractive equity valuations but also that such favorable value comparisons could easily survive both further stock price gains and the moderate rate increases contemplated by the Fed.<sup>8</sup></p>
<p>Meanwhile, prospects for continued, albeit moderate economic growth should spare equities the threat of recession and declining earnings, thus allowing them to realize their value. To be sure, all the forces that have kept the recovery subpar to date remain in place. Both company managements and lenders remain inordinately cautious, as a legacy of the pain of the Great Recession and in response to the continuing ambiguities of Washington’s active regulatory policies as well as the remaining uncertainties left by ambitious past legislation. But neither is there anything pre-recessionary about this economy, and it would be an economic downturn, not slow growth, that would prevent markets from realizing their value.</p>
<p>Three reference points at least direct clearly away from recession and toward continuing growth<sup>9</sup>:</p>
<p>1) The housing market is improving, not rapidly, but durably. The statistics record growth in sales, construction, and real estate prices. These are a long way from where they were before the housing bust of the Great Recession, and at their slow pace of advance, they will take a long time indeed to recover those highs. But in this context, the important thing is that the economy has never fallen into recession when real estate is improving, even if only slowly.</p>
<p>2) Corporate balance sheets are in great shape. There is, in fact, not a hint of excess. Nonfinancial corporations, according to Fed statistics, have checking account deposits equal to as much as 10% of their total liabilities, not even counting time deposits, money market accounts, and other cash equivalents. To be sure, managements are proceeding cautiously. They are neither hiring nor spending on expanded capacity nearly as aggressively as they once did. But recessions do not result from caution. They occur when companies are squeezed and have no option but to cut back, and with so much cash on its balance sheets, corporate America is far from squeezed.</p>
<p>3) Households, too, have improved their finances. The burden of debt service on aftertax income has fallen in the past two to three years, from about 20% to just over 15%. Though incomes have grown more slowly than they might because hiring has proceeded at a slower pace than in past recoveries, overtime and upgrading have allowed greater gross income growth for those who have jobs. So, although payrolls have expanded at an annual rate of only 1.5–2.0% during the past couple of years, aftertax incomes from wages and salaries have expanded at closer to 4.5–5.0%—not enough to create a consumption boom, but certainly enough to sustain an economic recovery.</p>
<p><b>Recap<br>
</b>If the great geopolitical issues of the day impose more uncertainty than usual, two factors make the economic and financial fundamentals look remarkably clear: 1) the Fed intends to raise interest rates, slowly and cautiously, but upward nonetheless, and 2) equity markets still show value, and continued economic growth, even if slow, should enable them to realize it. The first of these two considerations makes longer-term, quality fixed-income instruments less than attractive, though credit spreads remain attractive enough for investors to find good protection with more credit-sensitive instruments, especially municipal bonds, particularly in shorter durations. The latter consideration indicates that the equity rally should carry on, although likely not at the impressive pace it has put in to date.&nbsp;</p>
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<p><span class="legal"><sup>1</sup>&nbsp;Department of the Treasury.<br>
<sup>2</sup>&nbsp;Federal Reserve.<br>
<sup>3&nbsp;</sup>Ibid<br>
<sup>4&nbsp;</sup>Data from Bloomberg.<br>
<sup>5&nbsp;</sup>Ibid.<br>
<sup>6&nbsp;</sup>The S&amp;P 500<sup>®</sup>&nbsp;Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.<br>
<sup>7&nbsp;</sup>Data from Standard &amp; Poor’s.<br>
<sup>8&nbsp;</sup>Ibid.<br>
<sup>9&nbsp;</sup>Data for point 1 come from the Department of Commerce and the National Association of Realtors; data for point 2 come from the Federal Reserve; and data for point 3 come from the Federal Reserve, the Department of Labor, and the Department of Commerce.</span></p>
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Mon, 22 Dec 2014 08:51:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-housing-still-room-to-grow.htmlU.S. Housing: Still Room to Grow?<div class="everything">
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<h3><i>Federal Reserve rate hikes or not, the fundamentals suggest the sector’s slow, steady recovery likely will continue.</i></h3>
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<p>The prospect of Federal Reserve rate hikes has brought out much concern about the durability of the housing recovery. That is understandable. Any increase in rates threatens to raise the cost of supporting a mortgage, and the housing recovery, though far from following a powerful trend, has added to the admittedly tepid general recovery. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p>Still, it would be easy to exaggerate the impact of planned Fed actions. To begin with, policymakers intend to raise rates only slowly and cautiously. They will remain sensitive to the economy’s reaction, including housing. For another, housing remains historically affordable, so that any rate hikes, particularly the modest ones that this Fed contemplates, are not likely to shut down buying as dramatically as some seem to fear. Finally, other factors, most especially the willingness of banks to extend credit for real estate, likely will improve during the time before the Fed makes its rate moves. The housing recovery will, then, likely proceed, albeit slowly as it has to date, even after the Fed begins its promised rate increases.</p>
<p><b>The Recovery So Far<br>
</b>From its lows of 2009, the housing market has made an uneven, but on balance substantive recovery. It remains substandard, however, in two crucial respects, relative to past cyclical recoveries and especially compared to the precipitous drop that preceded it. Sales of new houses fell some 81% during the Great Recession, from a high of about 1.4 million units a year in 2005 to about 400,000 in spring 2009, when the general economic recovery began. The recessionary pressure in the sector was so powerful that even as the general recovery proceeded, sales of new homes actually fell an additional 32.5%, to lows of 270,000 in spring 2011. Only then, fully two years into the general economic recovery, did new homes begin their upturn. This growth proceeded in fits and starts, averaging about 17% a year, which is impressive in a vacuum, perhaps, but leaves housing nowhere near to recovering the ground it had lost. As of September this year (the most recent period for which data are available), sales of new homes stood at a yearly rate of 467,000, fully 66% below their former highs from before the bust of the Great Recession.<sup>1</sup>&nbsp; &nbsp; &nbsp;</p>
<p>New construction has followed a similar pattern. Housing starts peaked at an annual rate of 2.2 million units in fall 2005 and fell almost 78% during the Great Recession, to a low of 478,000, at an annual pace. They began a modest recovery in spring 2009 along with the overall economic recovery. But two years later, in spring 2011, when new home sales at last began to grow again, starts were only some 25% above their recession lows, a minuscule recovery given the steepness of the previous slide. The pace of recovery has picked up since, but in October 2014 (the most recent period for which data are available), starts averaged barely above 1.0 million a year, still almost 55% below their pre-recession highs.<sup>2</sup>&nbsp;&nbsp;</p>
<p>Though hardly impressive in light of the previous downturn, these gains have contributed to the economy’s overall growth path, though most of that help has emerged only recently. Early in the recovery, the housing growth was so slight that, according to the Bureau of Economic analysis at the Commerce Department, residential construction actually detracted from the pace of overall growth in 2010. Housing added a minuscule 0.02 percentage points a year to overall growth in the real gross domestic product (GDP) in 2011 and 2012. In 2013 and 2014 so far, it has added a still small 0.17 percentage points a year to overall growth.<sup>3</sup> Its contribution to employment gains has been only slightly better. Construction jobs accounted for only some 5.9% of total jobs created in the recovery since 2009, though during the past couple of years such jobs have averaged a modestly higher 8.5% of the total.<sup>4</sup></p>
<p><b>Reasons<br>
</b>The biggest help for housing so far has come from increased levels of affordability. The severe drop in real estate prices during the Great Recession and the even more precipitous drop in mortgage rates have lessened the burden of the average mortgage on the average family’s income. Here, the figures are striking. Between 2008 and 2011, when new home purchases finally turned up again, the median price of a single-family house in this country had fallen by more than 20%, according to the National Association of Realtors (NAR). The rate on the average fixed mortgage had dropped more than 200 basis points (bps), or by more than 30%, according to the Fed. The rate on a variable mortgage fell even more dramatically. Though the median family income actually fell during this time, these price and rate declines improved those families’ ability to support a mortgage. Affordability (to use the NAR’s term) improved more than 70%.</p>
<p>Two impediments held back the pace of recovery, however. One was the loss of confidence in the household sector. Concerns and insecurities engendered by the pain of the Great Recession dissuaded many from stretching—as they might have previously—for the house of their dreams. The second impediment to recovery was the decline in confidence among lenders. The huge mistakes of the housing boom and the subsequent losses during the recession prompted banks and other mortgage lenders to tighten credit standards in general and especially where residential real estate was concerned. Even as the overall recovery progressed, bank lending for real estate fell 5.5% in 2010, 3.8% in 2011, 1.1% in 2012, and 1.0% in 2013. It only just began to turn up this year, and then only at an average annual rate of less than 3.0%. As affordable as housing had become, borrowers simply could not get the necessary credit.&nbsp; Anecdotal evidence suggests that a great many of the purchases that did occur were made for cash, and by business or well-heeled buyers who planned to rent the properties rather than live in them.<sup>5</sup>&nbsp;</p>
<p><b>Prospects for the Future<br>
</b>This balance of forces seems poised to change, though it should still support a modest recovery going forward. On the negative side, rising real estate prices already have begun to erode the superior affordability comparisons. The prospect of Fed rate hikes likely assures further erosion on this score. No doubt, actions on both fronts will tend to squeeze out the marginal buyer and so tend to slow the housing recovery. But that should not halt growth altogether. &nbsp; &nbsp;</p>
<p>Even the prospective deterioration in affordability could hardly be described as intense. Housing, as mentioned, remains, in a historical context, affordable. Both real estate prices and mortgage rates are well below their former highs. Affordability, as calculated by the NAR, though down from its 2011 highs, remains 60% better than before the housing bust began and, remarkably, some 25% better than it averaged throughout the 1990s.<sup>6</sup>&nbsp;Even if mortgage rates were to rise by 100 bps and real estate prices were to accelerate their recent rising trend, it would still take until 2016 before affordability deteriorated to its state in the 1990s and early 2000, and much longer still to reach the kind of severe constraints that could create a downturn. And since the Fed has made clear its intentions to raise rates cautiously along a gentle path, it will no doubt take a good deal longer than this for it to add those 100 bps to mortgage rates.<sup>7</sup></p>
<p>If a gradual deterioration in affordability will tend to slow but not stop the housing expansion, other impediments, those holding housing back thus far, likely will improve. Homebuyers’ confidence and aggressiveness are, admittedly, hard to quantify, but signs of improvement are evident in the 11.5% rise during the past year in the University of Michigan’s consumer sentiment index.<sup>8</sup> Mortgage lenders also have begun to ease their former reluctance to extend credit for real estate. The Fed’s survey of senior lending offices describes an easing in requirements generally, a change that no doubt explains the real estate lending growth described earlier. These positives will no doubt develop only gradually. But at the margin, their turn should relieve the former drag on home-buying and so promote the general recovery in the area.<sup>9</sup>&nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>The pace of housing sales and construction might even quicken slightly under the changing mix of influences. A more conservative expectation would look for this changing mix of influences to sustain the housing recovery on the moderate path it has already established. Whatever record the precise statistics eventually show, investors can rest secure that, barring some presently unforeseen shock, a recovery will continue in one form or another for quite some time to come, despite plans at the Fed.</p>
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<p><span class="legal"><sup>1&nbsp;</sup>Data from the Department of Commerce.<br>
<sup>2&nbsp;</sup>Ibid.<br>
<sup>3&nbsp;</sup>Ibid.<br>
<sup>4</sup>&nbsp;Data from the Department of Labor.<br>
<sup>5</sup>&nbsp;Data from the Federal Reserve.<br>
<sup>6</sup>&nbsp;Data from the National Association of Realtors.<br>
<sup>7</sup>&nbsp;Data from the Federal Reserve.<br>
<sup>8</sup>&nbsp;Data from the University of Michigan.<br>
<sup>9</sup>&nbsp;Data from the Federal Reserve.</span></p>
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Mon, 15 Dec 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/stocks-going-with-the-flows.htmlStocks: Going with the Flows<div class="everything">
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<h3><i>Mutual-fund data show that retail investors remain reluctant to commit money to equities. That actually could help extend the rally in the months ahead.&nbsp;</i><b></b></h3>
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<p>To judge from money flows into and out of mutual funds, the scars of 2008–09 run deep. Perhaps that could be better described as the scars of the first decade of this century. Investors, particularly retail investors, suffered such shocking setbacks in stocks during those years that even now, after a tremendous equity rally, they remain reluctant to commit to the asset class. No doubt this reticence has kept the stock rally less extensive than it otherwise would have been. It also suggests that there is support for an extension of the rally—ammunition, so to speak, for further buying—especially if investors turn to the more aggressive investment approaches of the past.</p>
<p>Professional investors have talked of what they call “the great rotation” for some time now. They have anticipated that past gains in stocks would encourage retail investors to buy equities and prompt them to trade out of their fixed-income holdings or, at the very least, redirect their investment cash flows toward equities instead of bonds. According to mutual fund data collected by the Investment Company Institute (ICI), that rotation has yet to begin.</p>
<p>A year ago, it looked, for a while at least, as though retail investors were beginning the rotation. During the first nine months of 2013, funds flows, which had favored bonds for years and had come out of equities, began to turn. Overall bond mutual funds saw net outflows of $27.3 billion during that time, about $3.0 billion a month on average, mostly from municipals, while money market funds suffered outflows of $21.7 billion, $2.4 billion a month. Equities and hybrid funds received all those monies plus net new flows as well. Hybrids during this time enjoyed $64.3 billion in new flows, an average of $7.1 billion a month, while equities saw net inflows of $116.8 billion, about $13 billion a month.<sup>1</sup></p>
<p>But even as the stock market rally continued this year, the rotation hinted at in 2013 lost momentum. During the first nine months of this year, new fund flows into hybrids slowed by more than half to $31.9 billion, $3.5 billion a month. Net new flows into equities slowed by almost two-thirds, to $46.5 billion, which is only $5.2 billion a month. What is more, this gain was all in foreign equity investments, which enjoyed inflows of $80.3 billion, or $8.9 billion a month. Domestic equity funds actually saw a net outflow during this time of $33.8 billion, or $3.8 billion a month. Meanwhile, retail investors returned to bonds, which saw inflows of $45.4 billion during this nine-month stretch, or about $5.0 billion a month. The only trend of 2013 that saw an extension was the outflows from money market funds, which came in at $114.7 billion, almost $13.0 billion a month.</p>
<p>From early October and early November (the most recent time for which data are available), these anti-equity trends persisted. Domestic equity funds saw outflows of $1.5 billion during that one-month span. Hybrid funds saw net outflows of about $1.6 billion. Bond funds also lost, however. More than $7.1 billion flowed out of them during this one-month span. Presumably, some of these monies found their way back to money market funds, but the ICI does not provide such data on a frequent enough basis to state for sure.</p>
<p>The only way to explain such durable anti-equity biases is by reflecting back on the recent past. Bond investors since the turn of the century may not have done as well as in the prior 20 years, but have suffered less trauma than equity investors. They have seen the value of their assets cut by half or more for a time in two great market crashes. Over a 10-year period, for example, stocks, as measured by the S&amp;P 500<sup>®</sup> Index,<sup>2</sup> may have averaged annual returns well in excess of 8% a year and far better than bonds. But it is not the averages that stick in investors’ minds. It clearly is the shocks suffered between 2000 and 2002 and then again between 2007 and 2009.&nbsp;</p>
<p>The cautions, engendered by this history and evident in those fund flows, have, however, created an opportunity. By holding back the pace of the equity advance, they have kept stocks from fully realizing their value as quickly as they might have. That likely effect helps explain why equity yields still, even after all the gains of the past five years, look attractive, historically, next to bond yields. This fact and the clear indication that investors remain less than fully exposed to equities argue for a continuation of this equity rally. Only after the much-looked-for rotation occurs and investors have accumulated stocks as fully as in the past will they reach full valuations. In the meantime, further gains look likely.&nbsp;</p>
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<p><span class="legal"><sup>1&nbsp;</sup>All data herein from the Investment Company Institute (ICI).<br>
<sup>2&nbsp;</sup>The S&amp;P 500<sup>®</sup>&nbsp;Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. An index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.</span></p>
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Mon, 8 Dec 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-animal-spirits-remain-caged.htmlU.S. Economy: "Animal Spirits" Remain Caged<div class="everything">
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<h3><i>If the financial health of U.S. companies is so strong, why aren’t managers stepping up the pace of hiring and capital spending?</i></h3>
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<p>The market’s recent volatility has developed in response to at least one inscrutable fear and two fundamental matters. The inscrutable fear is Ebola. There is no way to forecast this sort of thing, no way carefully to weigh probabilities. Its impact emerges from periodic thinking about the worst. There is little that this column can offer here except to note that “the worst” seldom happens. One of the fundamentals is the mess in Europe. This space has offered a lot of commentary on this matter, little of it encouraging. (The latest piece, “<a href="/content/lordabbett/en/perspectives/economicinsights/europe-draghis-deflation-desperation.html">Europe: Draghi’s Deflation Desperation</a>,” appeared on October 13.)&nbsp; The other fundamental is the pace of this country’s economic recovery. Here, hopes of a durable acceleration alternate with the reality of disappointing results so far in this recovery. Other <i>Economic</i> <i>Insights</i> have dealt with this question, most recently the one on November 24 (“<a href="/content/lordabbett/en/perspectives/economicinsights/us-economy-getting-a-fix-on-growth.html">U.S. Economy: Getting a Fix on Growth</a>”). This column turns to evidence of the ongoing economic sluggishness and why, though recession is highly unlikely, the growth rate likely will remain disappointingly slow.</p>
<p>At the root of much of the recovery’s substandard character is the extremely cautious behavior of corporate managements and small-business owners. Firms surely have the wherewithal to support more aggressive rates of expansion. Profits and margins are strong, as are business balance sheets, remarkably so in fact. Yet, managements seem to lack the confidence they need to hire and spend and so drive the economy forward. The great economist John Maynard Keynes referred to this quality as “animal spirits.” And so hiring has remained historically restrained and so also, accordingly, have household incomes and spending, at least relative to past recoveries. Spending by businesses on new facilities, equipment, systems, and intellectual capital also has remained historically restrained. Nor are their signs of a change in such patterns, at least not significant enough to alter the substandard character of this recovery.</p>
<p><b>They Could Be Much Bolder<br>
</b>Certainly, managements have the resources to be much bolder than they have been. Non-financial corporations, for example, have seen the value of their financial assets jump 4.7% a year since 2009 and 4.8% a year since 2012. Their cash on hand has increased during these two periods at annual rates of 3.3% since 2009 and a whopping 5.8% rate since 2012. Cash holdings now exceed 10% of total liabilities. The value of their real estate assets have increased at a 9.1% annual rate since 2009 and at a still stronger 12.5% rate since 2012. Total assets have jumped at annual rates of 5.6% and 5.4% during these two respective periods. Business caution has, however, so held down the growth of liabilities that their net worth has jumped 6.5% a year since 2009 and 6.6% since 2012.<sup>1</sup>&nbsp; &nbsp;&nbsp;</p>
<p>This story of improvement and caution is much the same for smaller business. Nonfinancial, non-corporate firms in the United States have seen their total assets expand 9.5% a year since 2012. Their cash holdings have grown less impressively than those of larger companies, but like their larger brothers and sisters, caution in these smaller firms has held back increases in liabilities, which have expanded at only a 1.2% annual rate since 2009 and only a 1.9% rate since 2012. Their net worth, accordingly, has jumped at a 7.8% yearly rate since 2009 and a 6.6% rate since 2012. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Despite the impressive improvement in business’s financial resources, two considerations in particular have fostered continued reluctance. First is the legacy of the Great Recession of 2008–09—perhaps “wounds” is a better word. During that difficult time, managements came up short on several counts. Many report that they had trouble making payroll. The financial crisis that accompanied the recession exaggerated such pressure. Many small and quite a few larger firms found lenders less than eager to honor lines of credit previously arranged. Little wonder, then, that managements remain reluctant to use their assets and their cash as fully and as aggressively as they once did. On top of these powerful influences, Washington, beginning in 2009, passed a great deal of complex legislation. The Affordable Care Act and the Dodd-Frank financial reform legislation stand as prominent. Whatever the merits of these laws, their complexity created considerable uncertainty among managements about the costs of hiring or credit and even the availability of credit in the future, a consideration that greatly exacerbated the reluctances engendered by the recessionary experience.</p>
<p><b>The Evidence<br>
</b>Business has, accordingly, hired at a slower pace than in the past. Even the 2014 pickup in the pace of payroll growth falls short of the historical standard. So far this year, according to the Department of Labor, payrolls have grown on average by 226,667 a month, up from 194,250 a month in 2013 and 186,333 in 2012.<sup>2 </sup>Though this is a welcome improvement, past recoveries in the 1980s, 1990s, and earlier in this century saw much stronger payroll gains, often in excess of 300,000 a month. Reflecting the slow pace of hiring, real incomes during this recovery have grown less robustly than in past cycles. The lavish use of overtime and an upgrading in the average skillset of new employees have helped overcome some of the effects of the hiring shortfall, but not enough to change the adverse comparison. So far this year, overall real personal income has accelerated to a 3.6% annual pace of increase, from negligible growth in 2013 and 2012. Though this too is a welcome improvement, the established trend nonetheless remains well below that of past cyclical recoveries.</p>
<p>These increases are good enough to sustain consumer spending, and give some hope of an acceleration going forward, but nothing to match past cyclical recoveries. The strain is not just that households have seen their spendable resources grow along a shallow slope but also that their sense of the shortfall, and the still constrained jobs market, has kept them from extending themselves as they once would have. To be sure, this caution on the part of households does guard against an overextension that might, in time, lead to a bust, but it also blocks a rise to that happy medium between excess and greater levels of economic activity. &nbsp; &nbsp;</p>
<p>Managements have remained reluctant to spend and expand in other ways as well. The most telling sign here is how little their capital spending exceeds ongoing rates of depreciation. In past recoveries, companies quickly increased spending on new equipment, premises, and intellectual capital, increasing it on average from barely over depreciation during the recession to almost 45% above rates of depreciation in the early stages of recovery and even higher later in the expansion. But this time their caution has held them back, so that new spending on equipment, premises, systems, and intellectual capital, even after years of albeit slow recovery, still barely exceeds depreciation rates by 20%, less than half the historical average. Apart from directly holding down spending flows into the economy, this relatively timid behavior also limits future potentials for productive capabilities, productivity, hiring, and upgrading.<sup>3</sup>&nbsp;&nbsp;</p>
<p><b>If Not Now, When? &nbsp; &nbsp; &nbsp;&nbsp;<br>
</b>Sadly, there is little sign that the old “animal spirits” are likely to return quickly. Time, no doubt, will erase the bad memories of 2008–09 and perhaps permit more aggressive behavior among business managers. But as the evidence just presented indicates, it likely will take considerably longer before behavior changes substantively, and then the turn likely will occur only slowly. Meanwhile, the uncertainties connected with Washington’s ambitious legislation linger. Regulators have yet to write, much less clarify, many of the rules connected with the Dodd-Frank financial legislation, leaving all in business and finance up in the air about costs, availability, even required procedures in getting credit. There was some hope as 2014 approached that a full implementation of the Affordable Care Act would clarify its costs, benefits, and burdens. But so much of the bill has been modified temporarily—some for indefinite periods—that the most oppressive uncertainties remain in place. And all this offers ample reason to expect that this recovery will continue to remain historically slow, if perhaps not quite as substandard as it has been this far.&nbsp;</p>
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Mon, 1 Dec 2014 14:00:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-getting-a-fix-on-growth.htmlU.S. Economy: Getting a Fix on Growth<div class="everything">
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<p>With economic indicators swinging widely from one month to the next, it is harder than ever to get a fix on the underlying trends. At least it looks that way in the headlines. Fortunately, a little detail makes patterns clearer. The most information comes from a look at two subcategories of the gross domestic product (GDP): inventories and consumer spending. The picture that emerges points to likelihoods of continued sluggish growth that is broadly consistent with the pace of the recovery so far.</p>
<p><b>Inventories and Weather &nbsp;&nbsp;<br>
</b>The broad GDP figures give a good idea of the statistical confusion and how that has created swings in consensus sentiment. The top line of Table 1 tells the story. When, in the last quarter of 2012, the Commerce Department reported almost no growth in real GDP,<sup>1</sup> concerns immediately arose that a recessionary dip was in prospect. A resumption in the expansion during the first quarter of 2013 dissipated some of that fear, but it returned as the pace of economic advance slowed again in the spring quarter. Stronger growth in the second half of the year entirely dispelled recession fears and drove consensus thinking to look for an economic acceleration in 2014. But then an unseasonably severe winter depressed the first quarter. Though the reasons for the decline were obvious and clearly temporary, consensus thinking about fundamentals dipped along with the headline figures. A spring and slightly less pronounced summer surge in growth, though a predictable one-time catch up from weather-induced setbacks, seems nonetheless to have brought back renewed expectations for a fundamentally stronger economy.</p>
<p>If consensus thinking seems prone, as ever, to build on the most recent release, however obviously misleading, a look at some of the subcategories of the GDP can offer perspective, one that consensus thinkers might use, if, that is, they bothered to read more than headlines. The rest of Table 1 shows the relevant growth rates. Table 2 helps the analysis by showing the percentage-point contribution to overall real growth made within each major GDP subcategory.&nbsp;</p>
<p>Inventory movements are especially revealing. In the first quarter of 2012, a temporary surge in housing and business spending caught suppliers off guard. The depletion of their inventories shaved 0.2 percentage points off the overall pace of real growth and moderated the overall impact of the surge.&nbsp; When, predictably, these suppliers rebuilt their inventory stocks in the spring quarter, they added some 0.3 percentage points to overall growth. Since, however, housing and capital spending returned to their slower trends during that quarter, business needed to adjust inventory levels again. In the third and especially fourth quarter, they trimmed the inventories that they had mistakenly built up in spring. In the fourth quarter, these efforts alone cut 1.8 percentage points of overall growth, which, combined with a short-lived drop in government spending, created what was clearly a temporary interruption in growth though consensus thinking took it as more fundamental. &nbsp;</p>
<p><span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Table 1. Quarter-to-Quarter Growth, Selected Measures</span><br>
</b><i>Seasonally adjusted % change annualized rate</i><br>
<table class=no_style border="0" cellspacing="0" cellpadding="0" width="570">
<tbody><tr><td width="112" valign="top"><p>&nbsp;</p>
</td>
<td width="173" colspan="4" valign="top"><p>&nbsp;</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="190" colspan="4" valign="top"><p>&nbsp;</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="133" colspan="3" valign="top"><p>&nbsp;</p>
</td>
</tr><tr><td width="112" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="173" colspan="4" valign="top"><p><b>2012</b></p>
</td>
<td width="16" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="190" colspan="4" valign="top"><p><b>2013</b></p>
</td>
<td width="16" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="133" colspan="3" valign="top"><p><b>2014</b></p>
</td>
</tr><tr><td width="112" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="42" valign="top"><p><b>1</b></p>
</td>
<td width="40" valign="top"><p><b>2</b></p>
</td>
<td width="45" valign="top"><p><b>3</b></p>
</td>
<td width="45" valign="top"><p><b>4</b></p>
</td>
<td width="16" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="54" valign="top"><p><b>1</b></p>
</td>
<td width="45" valign="top"><p><b>2</b></p>
</td>
<td width="45" valign="top"><p><b>3</b></p>
</td>
<td width="45" valign="top"><p><b>4</b></p>
</td>
<td width="16" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="58" valign="top"><p><b>1</b></p>
</td>
<td width="40" valign="top"><p><b>2</b></p>
</td>
<td width="34" valign="top"><p><b>3</b></p>
</td>
</tr><tr><td width="112" valign="top"><p>Real GDP</p>
</td>
<td width="42" valign="top"><p>2.3</p>
</td>
<td width="40" valign="top"><p>1.6</p>
</td>
<td width="45" valign="top"><p>2.5</p>
</td>
<td width="45" valign="top"><p>0.1</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>2.7</p>
</td>
<td width="45" valign="top"><p>1.8</p>
</td>
<td width="45" valign="top"><p>4.5</p>
</td>
<td width="45" valign="top"><p>3.5</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>-2.1</p>
</td>
<td width="40" valign="top"><p>4.6</p>
</td>
<td width="34" valign="top"><p>3.5</p>
</td>
</tr><tr><td width="112" valign="top"><p>Consumer Spending</p>
</td>
<td width="42" valign="top"><p>2.8</p>
</td>
<td width="40" valign="top"><p>1.3</p>
</td>
<td width="45" valign="top"><p>1.9</p>
</td>
<td width="45" valign="top"><p>1.9</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>3.6</p>
</td>
<td width="45" valign="top"><p>1.8</p>
</td>
<td width="45" valign="top"><p>2.0</p>
</td>
<td width="45" valign="top"><p>3.7</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>1.2</p>
</td>
<td width="40" valign="top"><p>2.5</p>
</td>
<td width="34" valign="top"><p>1.8</p>
</td>
</tr><tr><td width="112" valign="top"><p>Capital Spending</p>
</td>
<td width="42" valign="top"><p>5.8</p>
</td>
<td width="40" valign="top"><p>4.4</p>
</td>
<td width="45" valign="top"><p>0.8</p>
</td>
<td width="45" valign="top"><p>3.6</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>1.5</p>
</td>
<td width="45" valign="top"><p>1.6</p>
</td>
<td width="45" valign="top"><p>5.5</p>
</td>
<td width="45" valign="top"><p>10.4</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>1.6</p>
</td>
<td width="40" valign="top"><p>9.7</p>
</td>
<td width="34" valign="top"><p>5.5</p>
</td>
</tr><tr><td width="112" valign="top"><p>Housing</p>
</td>
<td width="42" valign="top"><p>25.5</p>
</td>
<td width="40" valign="top"><p>4.3</p>
</td>
<td width="45" valign="top"><p>14.1</p>
</td>
<td width="45" valign="top"><p>20.4</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>7.8</p>
</td>
<td width="45" valign="top"><p>19.0</p>
</td>
<td width="45" valign="top"><p>11.2</p>
</td>
<td width="45" valign="top"><p>-8.5</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>-5.3</p>
</td>
<td width="40" valign="top"><p>8.8</p>
</td>
<td width="34" valign="top"><p>1.8</p>
</td>
</tr><tr><td width="112" valign="top"><p>Government</p>
</td>
<td width="42" valign="top"><p>-2.7</p>
</td>
<td width="40" valign="top"><p>-0.4</p>
</td>
<td width="45" valign="top"><p>2.7</p>
</td>
<td width="45" valign="top"><p>-6.0</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>-3.9</p>
</td>
<td width="45" valign="top"><p>0.2</p>
</td>
<td width="45" valign="top"><p>0.2</p>
</td>
<td width="45" valign="top"><p>-3.8</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>-0.8</p>
</td>
<td width="40" valign="top"><p>1.7</p>
</td>
<td width="34" valign="top"><p>4.6</p>
</td>
</tr><tr><td width="112" valign="top"><p>Final Sales</p>
</td>
<td width="42" valign="top"><p>2.5</p>
</td>
<td width="40" valign="top"><p>1.3</p>
</td>
<td width="45" valign="top"><p>2.7</p>
</td>
<td width="45" valign="top"><p>1.9</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>2.0</p>
</td>
<td width="45" valign="top"><p>1.5</p>
</td>
<td width="45" valign="top"><p>3.0</p>
</td>
<td width="45" valign="top"><p>3.8</p>
</td>
<td width="16" valign="top"><p>&nbsp;</p>
</td>
<td width="58" valign="top"><p>-0.9</p>
</td>
<td width="40" valign="top"><p>3.2</p>
</td>
<td width="34" valign="top"><p>4.1</p>
</td>
</tr></tbody></table>
</p>
<p><span class="legal">Source:&nbsp; Department of Commerce.</span></p>
<p><span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Table 2. Contributions to Real GDP Growth</span><br>
</b><i>Percentage points of the annualized figure</i></p>
<table class=no_style border="0" cellspacing="0" cellpadding="0" width="570">
<tbody><tr><td width="115" valign="top"><p>&nbsp;</p>
</td>
<td width="174" colspan="4" valign="top"><p>&nbsp;</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="186" colspan="4" valign="top"><p>&nbsp;</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="126" colspan="3" valign="top"><p>&nbsp;</p>
</td>
</tr><tr><td width="115" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="174" colspan="4" valign="top"><p><b>2012</b></p>
</td>
<td width="18" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="186" colspan="4" valign="top"><p><b>2013</b></p>
</td>
<td width="18" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="126" colspan="3" valign="top"><p><b>2014</b></p>
</td>
</tr><tr><td width="115" valign="top"><p>&nbsp;</p>
</td>
<td width="42" valign="top"><p><b>1</b></p>
</td>
<td width="42" valign="top"><p><b>2</b></p>
</td>
<td width="42" valign="top"><p><b>3</b></p>
</td>
<td width="48" valign="top"><p><b>4</b></p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p><b>1</b></p>
</td>
<td width="48" valign="top"><p><b>2</b></p>
</td>
<td width="42" valign="top"><p><b>3</b></p>
</td>
<td width="48" valign="top"><p><b>4</b></p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p><b>1</b></p>
</td>
<td width="36" valign="top"><p><b>2</b></p>
</td>
<td width="36" valign="top"><p><b>3</b></p>
</td>
</tr><tr><td width="115" valign="top"><p>Consumer</p>
</td>
<td width="42" valign="top"><p>1.9</p>
</td>
<td width="42" valign="top"><p>0.9</p>
</td>
<td width="42" valign="top"><p>1.3</p>
</td>
<td width="48" valign="top"><p>1.3</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p>2.5</p>
</td>
<td width="48" valign="top"><p>1.2</p>
</td>
<td width="42" valign="top"><p>1.4</p>
</td>
<td width="48" valign="top"><p>2.5</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>0.8</p>
</td>
<td width="36" valign="top"><p>1.8</p>
</td>
<td width="36" valign="top"><p>1.2</p>
</td>
</tr><tr><td width="115" valign="top"><p>Capital Spending</p>
</td>
<td width="42" valign="top"><p>0.7</p>
</td>
<td width="42" valign="top"><p>0.5</p>
</td>
<td width="42" valign="top"><p>0.1</p>
</td>
<td width="48" valign="top"><p>0.4</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p>0.2</p>
</td>
<td width="48" valign="top"><p>0.2</p>
</td>
<td width="42" valign="top"><p>0.7</p>
</td>
<td width="48" valign="top"><p>1.2</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>0.2</p>
</td>
<td width="36" valign="top"><p>1.2</p>
</td>
<td width="36" valign="top"><p>0.7</p>
</td>
</tr><tr><td width="115" valign="top"><p>Housing</p>
</td>
<td width="42" valign="top"><p>0.6</p>
</td>
<td width="42" valign="top"><p>0.1</p>
</td>
<td width="42" valign="top"><p>0.4</p>
</td>
<td width="48" valign="top"><p>0.5</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p>0.2</p>
</td>
<td width="48" valign="top"><p>0.5</p>
</td>
<td width="42" valign="top"><p>0.3</p>
</td>
<td width="48" valign="top"><p>-0.3</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>-0.2</p>
</td>
<td width="36" valign="top"><p>0.3</p>
</td>
<td width="36" valign="top"><p>0.1</p>
</td>
</tr><tr><td width="115" valign="top"><p>Government</p>
</td>
<td width="42" valign="top"><p>-0.6</p>
</td>
<td width="42" valign="top"><p>-0.1</p>
</td>
<td width="42" valign="top"><p>0.5</p>
</td>
<td width="48" valign="top"><p>-1.2</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p>-0.8</p>
</td>
<td width="48" valign="top"><p>0</p>
</td>
<td width="42" valign="top"><p>0</p>
</td>
<td width="48" valign="top"><p>-0.7</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>-0.2</p>
</td>
<td width="36" valign="top"><p>0.3</p>
</td>
<td width="36" valign="top"><p>0.8</p>
</td>
</tr><tr><td width="115" valign="top"><p>Inventories</p>
</td>
<td width="42" valign="top"><p>-0.2</p>
</td>
<td width="42" valign="top"><p>0.3</p>
</td>
<td width="42" valign="top"><p>-0.2</p>
</td>
<td width="48" valign="top"><p>-1.8</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="48" valign="top"><p>0.7</p>
</td>
<td width="48" valign="top"><p>0.3</p>
</td>
<td width="42" valign="top"><p>1.5</p>
</td>
<td width="48" valign="top"><p>-0.3</p>
</td>
<td width="18" valign="top"><p>&nbsp;</p>
</td>
<td width="54" valign="top"><p>-1.2</p>
</td>
<td width="36" valign="top"><p>1.4</p>
</td>
<td width="36" valign="top"><p>-.6</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Department of Commerce.</span></p>
<p><span class="separator">&nbsp;</span></p>
<p>Having gone too far with inventory reductions in 2012, business in 2013 returned to rebuilding. Their efforts added to overall growth, making the economy look much stronger than it in fact was. Final sales do a better job of capturing the fundamental, more moderate trend and show why, even as business added to inventories, the stage was set for a subsequent downward adjustment. Matters reached extremes during 2013’s third quarter. Then, inventory accumulations added 1.5 percentage points to the overall growth measure and made a slight uptick in final sales, to a 3.0% annualized rate of expansion, otherwise look like a boom. Then, in this year’s first quarter, unseasonably severe winter weather started the whipsaw again. It affected almost all sectors in the economy, but problems with shipping made for an especially sharp downward adjustment in inventories that turned a modest dip in final sales into a frighteningly sharp decline in overall GDP. The subsequent efforts of business to rebuild those inventories exaggerated an understandable, but relatively contained and short-lived, spring catch up from weather-related interruptions in construction and business spending. In the third quarter, an effort at moderation returned. Though seen this way, and it is clear that almost all was temporary, the economy, to those who just looked at the headlines, appeared to have surged.</p>
<p>Behind all this confusion and the swings in consensus opinion, final sales offered a much less volatile and more reliable picture of still moderate growth. The final sales figures, to be sure, are still highly variable quarter to quarter, but, as is also evident, they are much less wild and misleading than the overall real growth measure on the top line. What these figures show, in fact, is an economy that has tracked a modest expansion path since this recovery began in 2009, growing steadily but slower than usually. All but one quarter recorded growth below the long-term 3.5% historical annual real pace. There is, of course, a chance of an acceleration going forward. It could come from many directions, but, with the consumer still amounting to 70% of the economy, much will depend on how willing he and she are to depart from the cautious pattern they have pretty consistently held throughout this recovery. &nbsp;&nbsp;&nbsp;&nbsp;</p>
<p><b>The Consumer &nbsp; &nbsp; &nbsp;&nbsp;<br>
</b>What this recovery has shown thus far is a consumer constrained by three factors. First, the slow rate of expansion in the jobs market has held back income growth and with it the wherewithal to spend. Second, the slow rate of jobs and income growth has made consumers shy of resuming past, more aggressive spending patterns. Historically, they have increased spending ahead of income growth on the assumption that an improving economy will catch them up to higher spending levels. Third, the scars left by the 2008–09 Great Recession and the attendant financial crisis have greatly exaggerated this caution.</p>
<p>Substandard jobs growth constitutes one root of this atypical caution. To be sure, the jobs picture has brightened some this year. Payrolls in 2014 have increased on average by 218,000 a month, compared with 194,000 in 2013 and 186,000 in 2012. This pace, however, is still historically disappointing. Past recoveries have done much better. Still, the modest 2014 acceleration in payrolls growth and very modest wage increase, due mostly to a greater use of overtime, have accelerated income growth modestly. Total employee compensation is up in nominal terms at an annualized pace of 5.2% so far this year, faster than the 4.1% recorded last year. That pickup should allow some acceleration in consumer spending, but even if households follow the relative income gains in lock step, they would still pick up consumption to slightly more than a 3.0% real growth, enough to accelerate the overall economy slightly, but not enough to change its still sluggish underlying character.</p>
<p>Then there is the added, critical question of caution. As already indicated, households have remained reluctant to follow their historical pattern of running ahead of income, foregoing saving and stepping up borrowing. Instead, they have saved more than in the past. Where once savings rates ran at 3.0–3.5% of aftertax income, they have in this recovery averaged 5.5–6.0%. During those few times when household spending has run ahead of income gains, such as the first and last quarters of 2013, and savings flows have fallen below 5.0% of aftertax income, households always have checked themselves in subsequent quarters, sharply slowed their rate of spending growth, and brought their savings flows back up toward 5.5%.</p>
<p>The greatest chance of an economic acceleration would emerge if households were to break this pattern, shed some of this caution, and return to past patterns. Clear improvements in their balance sheets certainly could support such a change in sentiment. Household net worth has gained 8.3% a year during the past two years. The value of household financial assets has risen 7.4% a year. Real estate values have risen 7.5% a year during this time. Owner equity in homes has jumped from 45.7% in 2012 to 53.6% presently.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>But while this balance sheet improvement could foster more aggressive spending and certainly argues against the possibility of a downturn, households do not seem likely to shed their caution just yet. Not only does their unusual preference for savings speak to ongoing caution but also so does their evident reluctance to expand liabilities of any kind, which, despite gains in assets, have only grown 1.1% a year during these last two years. With memories of the last recession lingering and a still-sluggish jobs market constraining income growth, people likely will remain reluctant to get too far ahead of themselves, making it therefore less than likely that the economy will accelerate substantially from the slow pace already set in this recovery.</p>
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Mon, 24 Nov 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-congress-10-post-election-moves-to-watch.htmlU.S. Congress: 10 Post-Election Moves to Watch<div class="everything">
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<h3><i>Amid the big changes in the U.S. capital, here are the potential legislative actions that could influence financial markets.</i></h3>
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<p>With the remarkable midterm election results, it is only natural to ask how Washington might change.&nbsp; Political forecasting, of course, makes market and economic forecasting look almost easy. Still, without any implication of what is good or bad or what should happen or not, the logic of the situation suggests a number of future congressional initiatives. Many likely will fail, vetoed by President Obama. But they will occupy the attention of financial markets and so affect pricing. Here are 10 of them to watch out for<sup>1</sup>:</p>
<p>1) Though the Republicans seem to have moved away from the idea of repealing the Affordable Care Act, they may well advance legislation to repeal the unpopular medical device tax presently in the law.</p>
<p>2) The Republican Congress also may look to remove the employer mandate from the law.</p>
<p>3) Congress may ease some of the capital requirements presently built into the Dodd-Frank financial legislation, particularly those aimed at large insurance companies.</p>
<p>4) There also is talk about imposing more governance and accountability on the Consumer Financial Protection Bureau created by Dodd-Frank, perhaps by creating an inspector general for it or a board of directors.</p>
<p>5) Also on the financial side, there is discussion of streamlining the processes surrounding financial institutions deemed too big to fail, though little detail on this point has emerged.</p>
<p>6) The Republican Congress also will likely strive to rein in President Obama’s regulatory agenda, especially the Environmental Protection Agency’s dealings with power utilities.</p>
<p>7) Congress likely will push for the Keystone XL pipeline and perhaps also introduce measures to expand facilities for the export of natural gas.</p>
<p>8) If anything, the Senate confirmation process for presidential appointees will become even tougher, most especially for any replacement of Attorney General Eric Holder, who is retiring.</p>
<p>9) With Senator John McCain (R-AZ) now chairing the Senate Armed Services Committee, a review of the missteps in Benghazi will remain in the headlines, as will efforts to “do more” against ISIS (Islamic State of Iraq and Syria) and in the Middle East generally. So far, that “more” remains vague and seems to exclude “boots on the ground.”</p>
<p>10) Debate will heat up on the expiring legislation that authorizes surveillance by the National Security Agency, though this would have been the case regardless of the election results.</p>
<p>Besides these 10 points, there is a potential for welcome tax reform, either on the corporate side alone or more generally. Though the two parties remain far apart on many of the details, as do the president and Congress, all the proposals share a general desire to lower statutory rates and make up the revenue difference, to a degree or entirely, by ridding the tax code of deductions and other breaks. There is room here for compromise, if the parties involved are capable of it. Such moves, probably more than anything else, would help the economy and financial markets.</p>
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<p><span class="legal"><sup>1</sup>&nbsp;See, Nick Timiraos and Colleen McCain Nelson, “Obama, GOP Begin Laying Out Road Map for Future,”<i>The Wall Street Journal</i>, November 5, 2014, and Vicki Needham, “Five Things That Would Change in a Republican-Led Senate,”&nbsp;<i>The Hill</i>, November 2, 2014.</span></p>
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Mon, 17 Nov 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/oil-prices-good-news-by-the-barrel.htmlOil Prices: Good News by the Barrel<div class="everything">
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<h3><i>Ignore the pessimists. Declining petroleum prices likely will give an overall boost to the U.S. economy</i>.</h3>
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<p>A few months ago, when the rise of ISIS (Islamic State of Iraq and Syria) pushed up oil prices, articles abounded about the danger posed to the U.S. and the global economy. Now that oil prices are falling, articles abound about the dangers to the economy of lower prices, sometimes by the same people. Can pessimism really have it both ways? The answer is “no.” While there are economic positives and negatives to just about everything, declining energy prices are on balance favorable for the economy. If they persist, they will boost growth rates. They already have helped reverse the market correction of a few weeks ago.</p>
<p><b>The Economic Effect<br>
</b>A recent <i>Wall Street Journal</i> article<sup>1</sup> summarized the negative view of reduced oil prices. It centers on the threat to the fracking energy boom. Noting that fracking is a relatively expensive way to lift oil, this argument frets that low prices will render much existing American production unprofitable. It goes on to point out that oil and gas extractions have increased their importance to the U.S. economy in general and increased the worries, accordingly, over the ripple effect from layoffs in the country’s new oil fields on consumer spending and on housing. The concern focuses on the centers of the new boom: North Dakota, Oklahoma, and Texas. All three states are leading growth centers. North Dakota stands out.&nbsp; Rich in the Bakken Shale deposits, the state’s economy grew 9.7% in real terms last year. Since the general economy is already growing much slower than normal, and certainly slower than these boom states, the loss of their superior growth, these concerned analysts contend, could shut down the recovery.<sup>2</sup>&nbsp; &nbsp;</p>
<p>While the logic here is not wrong, it certainly is incomplete. For one, the fracking revolution is not so fragile as implied by these pessimists. According to the International Energy Agency, only 4% of U.S. wells require oil above $80 a barrel for profitability. Other sources suggest that most of the shale oil production can remain profitable even if oil prices were to approach $50 a barrel. The same is true of the Canadian tar sands. Though the extraction industry has grown as a share of the economy, it still only accounts for 1.7% of the total. Even if it were to disappear altogether, though hardly likely, it would not take down the whole economy. Meanwhile, the Labor Department reports that oil and gas extractions, though booming, have accounted for only some 60,000 new jobs since 2010. Though a remarkable turn from past years, that entire amount equals less than a third of the average monthly jobs gain this year, and even if new exploration were to stop altogether, again hardly likely, the industry would not give up all these jobs.<sup>3</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Still more significant in this balance of good and bad is the positive impact of cheaper fuel on the American consumer and on most American industry. The Labor Department reports that the average family dedicates some 10% of its budget to fuels of all kinds. The 25% drop in oil prices since last June, then, amounts to what effectively is a spendable income gain of 2.5% and in just a few months, effectively a $373 billion addition to households’ gross spending power. Even if families spend a small portion of this freed-up money, it cannot help but boost the economy. Beyond this consumer effect, lower oil prices also benefit shipping, warehousing, manufacturing, and all the rest of American businesses that are net energy consumers. Taken together, these effects conservatively could add in excess of one percentage point to the economy’s annual pace of growth, more if prices fall further, less, obviously, if the relief proves short lived.<sup>4</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p><b>Relief for How Long?<br>
</b>Barring new problems in the Middle East, there is every reason to expect low prices to persist. Increased sources of oil and gas production—from fracking in the United States, tar sands in Canada, and, broadly, from technologies that permit greater recoveries from existing conventional wells—has enabled global oil output to climb by amounts approaching some 50% since 2010, far faster than demand, especially since the world’s economies are expanding only slowly.<sup>5</sup>&nbsp;What is more, oil finds in the South Atlantic, in Australian shale, and promise in the Russian Arctic indicate still greater supplies going forward. As a recent piece in this space, “<a href="/content/lordabbett/en/perspectives/economicinsights/oil-prices-fracking.html">Oil Prices: Fracking to the Rescue</a>” (July 14), explained, a strict supply-demand consideration would set prices even lower than they are today, perhaps to $60 a barrel.&nbsp;</p>
<p>But for all the favorable impact of new supplies, there is nonetheless still a meaningful chance of an upward price spike. The unstable Middle East remains, after all, an important source of oil. Some 35% of all the oil shipped in the world passes through the Persian Gulf. Any threat to that flow could force up oil prices, despite all the production gains made in the United States, Canada, Australia, and elsewhere. It was, after all, the threat ISIS leveled at Iraq’s oil fields that drove up prices from around $85 a barrel in late 2013 to more than $100 a barrel last spring, even with all the additional sources and production from elsewhere. No doubt prices have fallen recently because, contrary to earlier fears, Iraqi production has continued to reach markets. But the situation in Iraq is far from secure. A strong possibility of growing tension between the United States and Iran also remains. A reverse on any of these fronts could easily and quickly turn today’s favorable pricing picture on its head.<sup>6</sup></p>
<p>Indeed, the pressure of low prices on producers, Russia and Iran in particular, has created a powerful incentive for producers to foment just such problems. Tehran, for example, already has accused the United States of fostering the price decline in order to destabilize Iran’s economy. Apart from that country’s adolescent sense of self-importance, the damage to Iran’s economy, from the oil price declines and the sanctions, already has had a destabilizing effect and weakened the position, according to some reports, of the so-called moderate President Hassan Rouhani. He then has ample reason to introduce an element of uncertainty into world oil markets. So does Russia, which also has been hit by sanctions as well as the oil-price drop. With oil accounting for some 80% of that country’s exports and 50% of the Kremlin’s revenues, Russia’s leadership may well calculate that it has more to gain by making trouble than it does by cooperating in Europe and elsewhere.<sup>7</sup>&nbsp; &nbsp;&nbsp;</p>
<p><b>Pulling the Pieces Together<br>
</b>It would be foolhardy in the extreme to forecast geopolitical trouble on the basis of such pressures, however real or plausible. At the same time, these risks recommend against a smug reliance on favorable supply-demand calculations. What circumstances do allow is a threefold conclusion: 1) Contrary to some media suggestions, the fracking revolution by and large is not threatened by today’s reduced prices; 2) though straight supply-demand calculations suggest continued low prices, that prospect is less secure than many imply; and 3), for as long as prices remain low, the economy on balance should benefit and gain cumulatively the longer prices remain low.&nbsp;</p>
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Mon, 10 Nov 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-budget-who-pays-the-way.htmlU.S. Budget: Who Pays the Way?<div class="everything">
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<h3><i>Over time, how has the mix of U.S. government revenues shifted among individual, corporate, and payroll taxes? This is the second of two parts.</i></h3>
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<p>This week’s discussion is the second half of a look at the federal budget. Together, both parts should give readers perspective on who supports the government and how the government disposes of that support. <a href="/content/lordabbett/en/perspectives/economicinsights/us-budget-how-is-spending-trending.html">Last week’s discussion</a> looked at outlays, showing that entitlements entirely dominate spending, and that unless there is reform, they could squeeze out most other government priorities. This week’s discussion looks at the revenues. It shows how Washington for some time now has shown a reluctance to increase its total tax take from the economy, relying on sometimes huge deficits to make up the shortfall from spending. The government has, however, shifted the incidence of tax burdens, a trend the president’s latest budget plans to halt in coming years.</p>
<p><b>Revenues Overall &nbsp; &nbsp;<br>
</b>The historical record is clear. For 35 years after World War II, Washington took revenues from the economy at a faster rate than the economy grew. Right after the war, the tax take did decline, falling from more than 20% of the gross domestic product (GDP) during the conflict to a low of 14.1% of GDP in 1950. It rose again with the Korean War and fell afterward, but never back to the 1950 rate. By 1960, total revenues had risen to 17.3% of GDP, and by 1969, they touched 19.0%, after which the relentless rise all but stopped.<sup>1</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>It would seem from the record that a tax take approaching 20% of GDP is about as much as the American public will tolerate. Accordingly, the proportion of GDP taken in revenues ceased rising in the 1970s. The decade closed with the take still at about 19.0%. Ronald Reagan’s promised tax cuts took the total down to about 17.0% of GDP by the late 1980s, giving George H.W. Bush leeway to raise taxes to meet Washington’s ever growing demands for financial and economic resources, a step that Bill Clinton built on in the early 1990s. These increases brought revenues again up toward 20% of the economy in 2000, the last year of Clinton’s second term. Little wonder, then, that the budget showed a surplus. The market bust that followed, and then the Bush tax cuts, brought the tax take down again, to about 17.5%, during the last years of Bush’s time in office. Revenues fell further, to 14.6% of GDP in 2008–09, less because of policy then from the Great Recession’s impact on income and profits. But tax increases under President Obama and a modest cyclical recovery began to push the tax take up again.&nbsp; Still, the 2014 percentage of GDP, at 17.3%, remains below the practical ceiling of 20%. &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>The White House’s budget projections indicate plans to push toward this practical ceiling. Total revenues are expected to grow 7.1% a year over the next five years, far faster than the official 5.1% projection of nominal GDP growth. The difference should bring the revenues take up to 18.6% of the GDP by 2019. Whether that evokes another round of relief is up to the voters, and is anyone’s guess, especially now.</p>
<p><b>The Mix &nbsp; &nbsp; &nbsp; &nbsp;<br>
</b>Though Washington derives revenues from a broad array of taxes and fees, it has relied primarily on four sources: individual income taxes, corporate income taxes, payroll levies, and excise taxes. The mix has varied tremendously over time.&nbsp;</p>
<p>Individual income tax burdens show the most steady pattern. They, like the total, rose as a proportion of both GDP through the 1950s and 1960s, and, unlike the total, continued to rise relatively through 1970s, going from 5.6% of GDP (about 40% of all revenues) in 1950 to a high of 9.0% in 1982 (48.2% of all revenues). The Reagan tax cuts offered a reprieve in the mid-1980s, but individual income taxes, like overall revenues, were again rising relatively later in that decade and in the 1990s, outpacing nominal GDP growth, so that by the end of the century, they were again above 9.0% of the economy (just less than 50% of all revenues). The Bush tax cuts created another pause, but individual income taxes have again risen relatively with the Obama rate increases and the economic recovery’s impact on the progressive code. They should reach 8.0% of GDP this year (and constitute 46.2% of all revenues). The White House budget plans to increase individual income taxes a rapid 8.1% a year for the next five years, fast enough to push them to 9.2% of GDP (some 48.4% of all revenues) by 2019. &nbsp; &nbsp;</p>
<p>Corporate and payroll taxes, as well as excise taxes, have shown huge relative swings. In the 1950s, for instance, a legacy of heavy wartime taxes on profits, including what Washington called an “excess profits tax,” brought corporate income taxes to almost a third of total federal revenues and equal to almost 5% of the country’s GDP. During those years, payroll taxes for Social Security and what the Treasury calls “social insurance” constituted barely 10% to the government’s total revenue take and amounted to less than 2% of the total economy. Excise taxes, mostly tariffs, constituted almost 20% of Washington’s total tax take, more than 2.5% of GDP. These burdens switched dramatically in succeeding years. The growth in the welfare state made greater demands on payroll taxes, while tariff cuts drove down excise taxes and international competition did the same to corporate taxes. By 1992, as Bill Clinton took office, the switch was complete. Corporate taxes contributed less than 10% of the overall federal revenues take (1.6% of GDP), excise taxes constituted 4.2% (0.7% of GDP), and payroll taxes had risen to almost 38% of the total revenues take (6.4% of GDP).</p>
<p>These trends have stabilized during the Obama administration, probably less from explicit policy than because they had proceeded about as far as they could go. Payroll taxes, for instance, after reaching 6.1% of GDP on average toward the end of the first decade of this century (roughly 35% of the total federal tax take), have ceased their relative rise, holding about steady at these relative levels. The White House’s plan calls for a very slight relative decline to 31.1% of total revenues (5.9% of GDP) by 2019.&nbsp; Excise taxes have all but ceased to matter in the equation. They remain in the plan at about 3% of the total federal take (0.6% of GDP), more from levies on tobacco and alcohol than tariffs. Proposed corporate tax reforms, in which the code lowers statutory rates while shredding tax breaks, turn out in the president’s plan to raise revenues on balance. According to the budget document, corporate taxes will rise from 11.1% of the total tax take this year (1.9% of GDP) to 12.2% in 2019 (2.3% of GDP). &nbsp; &nbsp;&nbsp;</p>
<p><b>Takeaway &nbsp; &nbsp; &nbsp;<br>
</b>Except in the unlikely event that Washington forswears its ever-growing economic and financial demands, this revenues picture makes a powerful case for major tax reform. The country could benefit from a reduction in payroll taxes. To be sure, they have increased because of their natural link to social spending. But these high rates nonetheless discourage job creation among employers and discourage paid work generally among the population. They are regressive, too, falling relatively hardest on poorer workers, who never reach the point where some payroll taxes top out and in any case pay at the same rate as high-income earners. Since excise taxes can in no way take up the slack and corporate tax hikes would impair international competitiveness, the only place to make up the difference would seem to lie with personal income taxes. It would, however, be less than productive simply to expand the existing structure. The economically efficient way to absorb the burden would involve a broadening of the tax base, a lowering the statutory rate, and simultaneously ending many of the long list of tax deductions that mostly benefit higher-income people. It is encouraging that both sides of the aisle in Washington are considering such reforms, but discouraging that the present rancor in the capital precludes any progress, probably until after the next presidential election.&nbsp;</p>
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Mon, 3 Nov 2014 10:01:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/quarterly-roundtable-us-economy-just-the-cleanest-dirty-shirt.htmlQuarterly Roundtable: U.S. Economy—Just the Cleanest Dirty Shirt<div class="everything">
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<h3><i>The recent surge is not likely to continue, but obstacles to growth are even greater elsewhere.</i></h3>
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<p><b>In Brief</b></p>
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<li>The U.S. economy grew by an annualized rate of 4.6% in the second quarter of 2014, according to the Bureau of Economic Analysis, marking the third quarter in the last four in which real economic growth exceeded 3.5%.</li>
<li>It appears unlikely, however, that the recovery will continue at this pace. Various structural factors and other longer-term impediments stand in the way of a stronger expansion.</li>
<li>But it’s also unlikely that the U.S. economy is in a period of “secular stagnation,” as some economists have suggested. Secular stagnation suggests the economy’s performance would be impervious to policy improvements. In reality, although there are secular aspects to the current sluggishness, certain structural reforms would probably produce higher growth.</li>
<li>The European Central Bank recently cut its benchmark interest rate and has begun to embark on a policy of quantitative easing. But monetary policy may have reached its limit, and may have already created other problems, including a credit bubble in emerging markets.</li>
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<p>The U.S. economy expanded by an annualized rate of 4.6% in the second quarter of 2014, rebounding sharply from the first quarter’s 2.1% contraction. In fact, gross domestic product (GDP) has risen by more than 3.5% annualized in three of the last four quarters. But a number of factors suggest the economy will soon return to its muddle-through pace of the past several years.</p>
<p>Some economists have even raised the possibility of “secular stagnation,” given that the problem of tepid growth, even in a loose-money environment, predates the financial crisis of 2008–09. Nevertheless, for the time being, the pace of growth appears practically torrid when compared with rest of the developed world. The eurozone continues to slump, and now faces the possibility of deflation. The European Central Bank (ECB) recently cut its benchmark interest rate and will soon begin a type of quantitative easing, though it faces some resistance. These policies do not come without a price, however, and the Bank for International Settlements (BIS) has indicated that monetary policy in the developed world is too loose, resulting in asset bubbles and excessive levels of debt in emerging markets.</p>
<p>Tackling these and other issues are <b>Lord Abbett Partners <a href="/content/lordabbett/en/global/biographies/milton-ezrati.html">Milton Ezrati</a>, Senior Economist and Market Strategist; <a href="/content/lordabbett/en/global/biographies/zane-brown.html">Zane Brown</a>, Fixed Income Strategist; </b>and<b> <a href="/content/lordabbett/en/global/biographies/harold-sharon.html">Harold Sharon</a>, International Strategist.</b></p>
<p><b>Q. GDP has grown by 3.5% or more in three of the last four quarters, starting in third quarter 2013. Is the recovery finally kicking into high gear?</b></p>
<p><b>Ezrati:</b>&nbsp;I’m skeptical that growth is going to continue at this level. What we’ve seen recently are surges that are not sustainable. We saw a surge in inventories in the third quarter of 2013, followed by a drop in the fourth. Housing was also weak in the fourth quarter, but the weakness in inventories and housing were more than covered by a surge in consumer spending. In the first quarter of this year, growth was -2.1%, in part due to the weather, but also because consumers pulled back after outspending their income growth in the previous quarter.</p>
<p>In the second quarter of 2014, we saw a surge in housing, manufacturing orders, and construction activity, but these were all rebounds from the weather-related slowdowns in the first quarter. What we’ve seen so far in the third quarter is a response to these second-quarter surges—a decline in manufacturing orders and a decline in construction spending. So, I’m skeptical that GDP can continue at the 4.6% rate of the second quarter.&nbsp;</p>
<p>Even with the strong performance recently, GDP growth has averaged only 2.6% over the past four quarters.</p>
<p><b>Brown:</b>&nbsp;It’s hard to believe that we could be growing 3–4% a year, because job growth is only around 200,000–215,000 per month [according to the Bureau of Labor Statistics] and wage growth is barely keeping up with inflation. Also, in the second quarter of 2014, people began purchasing health insurance under the Affordable Care Act, and that could spill over into the third quarter as well. Although this contributed to GDP in the second quarter and will also contribute in the third quarter, it’s essentially a one-time increase; it won’t continue much after that.&nbsp;</p>
<p>So, that’s another reason this pace of growth is probably sustainable.</p>
<p><b>Ezrati:</b>&nbsp;If consumers start outspending their incomes on a regular basis, which they did in the fourth quarter of 2013, this surge will come to an end very quickly, because they’ll become stretched and will have to pull back. So, unless businesses start hiring and start investing the cash on their balance sheets, this won’t continue. So, I don’t think we’re off to the races yet.</p>
<p><b>Q. If the recent surge in growth is not sustainable, is it possible that the U.S. economy has entered a period of “secular stagnation,” as some economists [such as Larry Summers, former director of the White House U.S. National Economic Council under President Obama; Minneapolis Fed president Narayana Kocherlakota; and Fed vice chairman Stanley Fischer] have suggested?</b></p>
<p><b>Ezrati:</b>&nbsp;There are demographic reasons for the slow growth of the economy, but there are cyclical things going on as well. The recession was inordinately deep, for reasons we’ve discussed, and it’s left a legacy of caution that weighs on the growth rate. But that won’t last forever. So, Summers might be right about the demographics and other structural reasons for the economic sluggishness, but that doesn’t mean that the growth rate needs to be 2.0% or less forever.</p>
<p><b>Brown:</b>&nbsp;I think there are structural aspects to the economy’s sluggishness. baby boomers are retiring, downsizing, and spending less. Also, the millennials are not that interested in household formation, and they’re more interested in renting than owning. These trends are present in other developed economies as well. That means that unlike in the past when we experienced a cyclical downturn, other economies won’t be able to help pull us out of it.</p>
<p><b>Ezrati:</b>&nbsp;The mismatch in skills between what employers need and what the labor force has to offer may also be contributing to the downturn by keeping the unemployment rate high. And that won’t be solved overnight; as the economy continues to become more knowledge-based, workers who lack those skills are having a harder time finding work.</p>
<p>There are two other factors hindering this economy. One is the legacy of the Great Recession. Business spending and hiring don’t occur unless management becomes more aggressive, but the experience of 2008–09 has scarred them. I think the amount of cash sitting on corporate balance sheets is evidence of that. Because of that experience, and because of the difficulty they may have had obtaining financing at that time, firms feel they must be self-financing.</p>
<p>The other factor is the regulatory environment. The Affordable Care Act and the Dodd-Frank financial reform legislation created a lot of uncertainty. Congress is not passing much legislation now, but what they have passed remains ambiguous. The requirements of the Affordable Care Act, for example, are still unclear, and I don’t see that changing anytime soon.</p>
<p>On the bright side, increased M&amp;A [mergers and acquisitions] activity is one sign of life in the economy. It means that businesses are again willing to take risks and is evidence of what [British economist John Maynard] Keynes called “animal spirits.”</p>
<p><b>Brown:</b>&nbsp;It is positive in that sense, but M&amp;As contribute to the unemployment problem because they usually result in layoffs. They are also a reaction to the limited opportunities to invest in organic growth. Because the economy is growing so slowly, companies can’t justify investing in their own new growth, so instead they buy existing growth by acquiring a company. But that often means eliminating employees that are duplicative, such as a sales force, for example.</p>
<p><b>Q. The U.S. Federal Reserve is ending its quantitative-easing program, and expects to raise the fed funds rate by mid-2015. In Europe, the ECB is facing resistance to its quantitative-easing program. Can the global economy grow without extraordinarily accommodative monetary policy? &nbsp;</b></p>
<p><b>Brown:</b>&nbsp;Monetary policy has pretty much done all it can globally. Europe is taking a more targeted approach with its purchase of asset-backed securities, but in the grand scheme of things, that program won’t be enough to get those economies going. What is necessary is structural reforms that will make them more competitive.</p>
<p><b>Ezrati:&nbsp;</b>Fiscal stimulus is out of the question. If the eurozone were to give up on its budget constraints, it could run out of room to borrow. With France, for example, there’s so much debt out there on the market already, that if France showed any sign of losing its commitment to fiscal austerity, the investment community would walk away from French debt.</p>
<p><b>Sharon:</b>&nbsp;This does point out the pressure for government authorities to truly focus on growth-enhancing programs and policies. Policies on the fiscal side have just disappointed massively around the world. We’ve seen very few government privatizations or rollbacks of government interference in large economies. I would hope that as monetary policy stimulus fades, we’ll see more on the fiscal side everywhere.</p>
<p><b>Brown:</b>&nbsp;Can the global economy grow without easy money? We’re going to find out. It’s not growing very rapidly even with easy money. The United States has been growing at around 2–2.6% in real terms, even with easy money, so the question becomes, what will happen when the Fed begins to raise rates? If the Fed does that aggressively, you would think it would have some impact on growth.</p>
<p>But the Fed might not be as aggressive as its interest-rate projections imply. The Fed suggests that by the end of next year, the fed funds rate will be between 1.25% and 1.5%. What that implies is that it will make five or six consecutive quarter-point moves, starting in April 2015. I don’t think anybody is expecting a rate hike that soon. &nbsp;</p>
<p>If the market is looking out that far, which I’m not sure is the case, it would be easy to come to the conclusion that the Fed cannot be as aggressive as it is suggesting. An aggressive stance by the Fed would hurt housing. So far, the housing recovery has been supported mostly by investors taking advantage of low prices and foreclosures. Prices have risen and foreclosures have slowed, so now would be the time that low interest rates would help homebuyers, those that want to buy the home to live in it. But now interest rates are probably going to rise. So, will rising rates affect the housing market? I think so.</p>
<p>Also, at its meeting in June 2014, the Fed said it expected 3.1% growth in 2015. At this last meeting [in September 2014], it lowered its expectation to 2.8%. Also, in June, the midpoint of the Fed’s interest rate projections for year-end 2015 was 1.13%. But at the September meeting, the midpoint was 1.38%. That means that in a slower-growth environment, the Fed supposedly will be more aggressive in raising rates.</p>
<p>So, I think their interest-rate projections are optimistic. The bottom line is that I don’t think growth will be strong enough to allow the Fed to be so aggressive. That doesn’t directly answer your question about whether the economy can grow without easy money, but I think the Fed will handle these rate increases delicately. But I don’t think the rest of the world is ready to abandon easy money policies.</p>
<p><b>Q. The Bank for International Settlements [BIS] said in its annual report that monetary policy around the world is too loose, and that this is leading to bubbles in capital markets. Has the market priced in interest rate increases? Is the stock market, or parts of it, such as technology, in a bubble? Is the bond market?</b></p>
<p><b>Ezrati:</b>&nbsp;As far as the U.S. stock market goes, it’s near new highs, but price-to-earnings [P/E] multiples are about where they’ve been over the past 35 years. Relative to cash and relative to bonds, the market looks cheap. So I don’t see where the BIS is getting the idea that the market is irrational, euphoric, or disconnected from fundamentals.</p>
<p><b>Brown:</b>&nbsp;As for bonds, I think we’re far from a bubble in most categories, with the exception of Treasuries. Treasury securities really are priced too high. They’re artificially low in yields because of the Fed’s zero-interest rate policy and because of quantitative easing. So relative to inflation and relative to our economic growth, they are too low.</p>
<p>But yield spreads on investment-grade bonds relative to Treasuries are wider than average. In the high-yield market, spreads are narrower than average, but at 500 basis points [bps] [as of September 30, 2014; all yield spread data is from Bloomberg, unless otherwise noted], they are a far cry from the previous low, which was 270 bps. So, are bonds in a bubble? No. The only category that appears to be overpriced is Treasuries, and the Fed is in the process of letting the air out of that market by ending its quantitative-easing program.</p>
<p>As for stocks, Strategas Research has pointed out that profit margins are continuing to expand. This means that even in our current slow-growth economy, the market could produce a reasonable return. If nominal GDP grows by about 4%, if overseas earnings grow, and if companies continue to buy back shares, the market could produce a return in the mid to high single digits. That’s even if P/E multiples don’t rise. So even if we get that kind of return over the next 12 months, it would be hard to characterize a market like this—which continues to rise, but only enough to keep up with increased earnings—as being in a bubble.</p>
<p>By the way, as Milton has pointed out in the past, corporate profit margins have been high because of operating leverage. In the wake of the financial crisis, businesses invested a lot in equipment and machinery, so they now have higher fixed costs than in the past. That means that once sales are high enough to cover those fixed costs, any additional sales that occur primarily have to cover variable costs, so the bulk of those revenues go to the bottom line.</p>
<p>As for the BIS, it could be that its statements are being driven by an agenda. The BIS is an organization of central bankers, so they may be trying to send a message that fiscal policy needs to change and structural reforms are needed. In other words, monetary policy cannot solve the economic problems in developed markets.&nbsp;</p>
<p><b>Ezrati:</b>&nbsp;The other thing to note is that the economy is still operating at less than 80% capacity, so that suggests there’s room for even more operating leverage.</p>
<p><b>Brown:</b>&nbsp;The bond market in Europe, on the other hand, is another story. I think that’s pretty dangerous, given the possibility of negative economic growth. Yields in the high-yield market are almost 100 bps lower than they are here. That’s where there is really some risk. An economic slowdown could result in a lot of bankruptcies and a significant loss of principal.</p>
<p><b>Ezrati:</b>&nbsp;Europe faces the possibility of deflation, so the low nominal yields may be sustainable, but in a deflationary economy the outstanding debt becomes larger and larger relative to the rest of the economy, so it becomes a greater burden for countries that are already overburdened with debt.</p>
<p>The strategy that the ECB has been using to combat deflation is coming unwrapped. Although the bank has lowered interest rates, it has, in effect, raised real [inflation-adjusted] interest rates. Two years ago, the benchmark rate was 1.5% and inflation was 2.5%, so the real rate was -1% [1.5%-2.5%=-1.0%].&nbsp; Today, the benchmark interest rate is 0.15% and inflation is .30%, which means that the real rate is -0.15%. That means that the ECB has raised the real interest rate from -1.0% to -0.15%, or 85 bps [-1.00-(-0.15) =-0.85] over the past two years.</p>
<p><b>Brown:</b> What is needed is some kind of policy to provoke growth or labor market reform to make the eurozone more competitive internationally. But there is no effort underway to make the necessary reforms, so the prospects of the eurozone turning around anytime soon are pretty minimal.</p>
<p><b>Ezrati:</b>&nbsp;Italy was making an effort a few years ago under then-Prime Minister Mario Monti, and today Prime Minister Matteo Renzi is talking about reform, but nothing is happening. In France, it seems that whatever concessions the government gives with one hand, it takes away with the other. So it might provide relief for corporations by reducing employment-related taxes, but make that up by increasing the value-added tax. So, in effect, there’s no relief in taxes, just a shift.</p>
<p>The other thing they do in Europe is subsidize inefficient factories in order to keep people working. According to <i>The Wall Street Journal</i>, there’s a refinery in Sicily that has lost €10 billion over the last five years. Demand for refined petroleum products is down 30% since 2006, but the company is not allowed to close the refinery. The article also mentioned that Italy also recently gave tax breaks to Electrolux, the appliance maker, to keep factories open that Electrolux wants to close. Last year, Bloomberg reported that if auto production capacity in Europe matched to demand, 18 auto plants would be closed. That’s one reason Europe has deflation—because they’ve got this glut of products.</p>
<p><b>Q. Easy money has led to troubling debt levels, especially in emerging markets [EM], according to the BIS, and these markets are much bigger today than when the Asian crisis hit in the late 1990s. China, in particular, has had a boom in consumer lending for the past five years. How much of a threat is EM debt?</b></p>
<p><b>Ezrati:</b>&nbsp;In the 1990s, one of the things that hurt emerging markets was that all their debt was in U.S. dollars. So, when their currencies depreciated, they couldn’t repay it. Today, much of the sovereign debt, at least, is in local currencies.</p>
<p><b>Brown:</b>&nbsp;Corporate debt is still largely in dollars, however. In places like Brazil, which was growing very rapidly a few years ago, a lot of companies issued debt to finance huge expansions to expand their capacity and capitalize on the growth. But today, the Brazilian economy has slowed and the global economy has slowed. And, unfortunately, this debt is dollar-denominated, while their revenues are largely in Brazil’s currency, the real. At the time, issuing debt in dollars made sense because money could be raised quickly and at low rates.</p>
<p>But now, with the dollar strengthening, the real is worth less and less, making debt payments for these companies more and more difficult. So there could be a rise in corporate defaults as a result.</p>
<p><b>Ezrati:</b>&nbsp;They’re in the same boat that many Asian countries were in in the late 1990s.</p>
<p><b>Brown:</b>&nbsp;The situation is China is different, but still pretty alarming. The property market accounts for between 20-30% of GDP, according to Bloomberg data, and sales and values have been falling. The <i>Wall Street Journal</i> reported that housing sales dropped nearly 11% in the first eight months of 2014, and prices fell more than 3% between April and September. The decline in prices may not sound like much, but the <i>Journal</i> said it’s about the same decline that occurred over a 10-month period in 2011-12. So, the decline this time has been more rapid.</p>
<p>There’s not as much leverage in the housing market as we have here. Homebuyers will often make down payments of 30–50%, but this drop in home values means that consumers can’t act with the same level of confidence that they have in the past.</p>
<p>Foreign direct investment has also declined for the first time in years. Manufacturing costs are higher now even relative to the United States. So, they don’t have the same cost advantage they had years ago. So, China may not achieve the 7.5% growth that they have targeted.</p>
<p><b>Sharon:</b>&nbsp;There has been a large build-up of debt in many emerging economies since the financial crisis.&nbsp; In essence, as exports to the developed world slowed, many emerging economies, and China in particular, bridged the growth gap by substituting a credit-fueled economy for their export-led economies. As Milton said, at least this time the debt is mostly local, and with companies and individuals, not governments. But as we’ve seen in the past, these emerging market credit cycles always produced a bad-debt cycle at some point.</p>
<p>China’s government has the wherewithal to take on the bad debt if necessary, but other emerging markets, such as South Africa, Indonesia, or Turkey, don’t have that luxury. We’ve already seen a few spectacular EM company debt blowups, and I suspect we’ll see more, especially in Eastern Europe, given the sanctions on Russia.</p>
<p><b>Q. What are the investment implications of this slow-growth, loose money environment? &nbsp;</b></p>
<p><b>Brown:</b>&nbsp;I think U.S. equities still have a reasonable chance to produce an 8–10% return over the next 12 months. And that probably will exceed any returns in any segment of the fixed-income market if the Fed is able to begin adjusting rates higher. Even high yield may not give you that kind of a return, because the coupon is around 625 bps [as of September 30, 2014], and with interest rates likely to rise, there will be some loss of principal.</p>
<p><b>Ezrati:</b>&nbsp;On the equity side, among developed markets, I think the United States is preferable on a risk-adjusted basis, even though valuations are lower in Europe and Japan. On a risk-adjusted basis, I would still favor the United States because Japan has structural economic problems that they still have not dealt with. In Europe, they have the economic sluggishness that we’ve discussed here, and they’re not dealing with it. And I would add that Europe is closer to Ukraine and Japan is closer to North Korea.</p>
<p><b>Brown:</b>&nbsp;So the threat of geopolitical risk is greater in those markets. But there are likely to be large exporting companies that are likely to get most of their revenues from outside Europe, and there may be opportunities among those companies.</p>
<p><b>Ezrati: </b>From an asset allocation perspective, the U.S. stock market is more attractive, but from a stock-picking perspective, the more fertile fields may be in Europe and Japan.</p>
<p><b>Sharon:</b>&nbsp;I agree with my colleagues, but I think the time to reenter the European markets may be early next year, when the ECB has given an “all-clear” signal as the new bank regulator in Europe. The nagging issue of European bank solvency will be, for all intents and purposes, closed; it won’t be viewed as a potentially systemic threat. By early next year, we’ll know what the level of liquidity and capital is in the system, and that will force the banks to get to the ECB’s desired level.&nbsp;</p>
<p>The optimistic scenario would be that at the same time that we see more policies aimed at boosting economic growth and employment, and reducing austerity, that the depressing signals we now see in Europe will turn for the better. It will not be rapid, but the decline in the current market and in the currency could provide a nice entry point later for a potentially less bad 2015. That would surprise markets and make for reasonably good equity returns.</p>
<p><b>Q. Thank you, gentlemen.</b></p>
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Mon, 27 Oct 2014 11:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-budget-how-is-spending-trending.htmlU.S. Budget: How Is Spending Trending?<div class="everything">
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<h3><i>With the pivotal 2014 midterm election around the corner, here is the first of a two-part look at both sides of the U.S. budget. First up: Examining where U.S. taxpayers’ money actually goes—and whether current spending trends are sustainable.</i></h3>
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<p>With the country set to elect a new Congress in just a few weeks and the 2016 presidential contest already in the news, this space aims, as a kind of public service, to look at who in the country pays for all Washington does and where Washington spends those funds. Perhaps the analysis will help readers, whether financial advisors or investors, pierce the fog and misinformation that inevitably accompanies election campaigns. To make what is a tsunami of data more digestible, this effort will come in two parts. This first number will take up spending, what Washington prefers to call outlays. It will show that without entitlements reform, virtually all the promises likely in the campaigns will be financially dubious. Next week’s discussion will look at the revenue side of the budget to see who supports the structure.</p>
<p><b>Overview &nbsp;&nbsp;<br>
</b>According to the president’s most recent budget,<sup>1</sup> overall federal spending is scheduled to rise 5.3% a year between fiscal 2014 and fiscal 2019. This is slightly faster than the 5.1% rate the White House expects for growth in the nominal gross domestic product (GDP). Accordingly, the White House estimates a modest rise in what the government takes from the economy. Federal spending, according to these estimates, will rise from 21.1% of GDP presently to 21.3% by the end of this period. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Chances are that the government will end up taking a bigger share of the economy when all is said and done. There are at least two reasons. First, the White House’s economic growth projections lean toward the optimistic side. The administration expects real growth of 3.1% a year on average over these five years—a figure that exceeds the trends witnessed thus far in this recovery. Though an economic acceleration is possible, present signs hardly make it look likely. Nor do these projections admit to a recession, implying an unprecedented and unlikely recession-free 10-year stretch from 2009, when this recovery began, to 2019, the end date of the forecast period. Second, much of the projected budget savings comes out of defense (more on this below). With the fighting now in the Middle East as well as tensions with Russia, those cuts may not occur, and surely will fail to go as deep as the White House budget implies. &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>However much faster than GDP federal spending grows, the trend certainly fits with history. For more than 65 years now, government outlays have outpaced nominal GDP through both Republican and Democratic administrations and Congresses. They rose from 11.3% of GDP in 1948 to 20.6% in 1998, gaining on average slightly more than 0.2 percentage points of GDP a year throughout this time. The pattern broke briefly at the turn of the century, when the so-called “peace dividend” that came with the end of the Cold War slowed the pace of overall federal outlays below that of the overall economy and Washington’s spending fell three full percentage points of GDP, to 17.6% by 2001. Thereafter, the old pace of relative expansion resumed, in response to the continued expansion of the welfare state plus the Iraq and Afghan wars. Under both President Bush and President Obama, spending gained share of GDP by just about the historical pace of 0.2 percentage points a year. Applying this well-established trend to coming years would take federal spending up to a level more like 22.1% of GDP by 2019, well above the White House projection of 21.3%.</p>
<p><b>The Big Pieces—Defense and Entitlements—Combined Are Almost 90% of All Outlays &nbsp; &nbsp; &nbsp; &nbsp;<br>
</b>As already indicated, the White House expects savings from defense-spending cuts. It projects a 3.0% drop in Pentagon outlays each year between now and 2019. That would take the defense allocation from its current level of 3.6% of GDP (20.1% of the budget) to 2.6% of the GDP (16.2% of the budget) by 2019.&nbsp;</p>
<p>Even before the recent trouble in the Middle East and Ukraine, this was an ambitious goal. To be sure, defense spending has trended down relatively for a long time. In the 1950s, even removing the effects of the Korean War, spending by the Pentagon averaged almost 10% of GDP and amounted to more than half of government spending. From the 1960s through the 1980s, it averaged more than 6.0% of GDP and about one-third of all federal spending. By the end of that decade, it was running about 4.5–5.0% of GDP. It did fall briefly below 3.0% of GDP between 1999 and 2001 because of the Cold War peace dividend, but picked right up again with the “War on Terror.” Even then, it came nowhere near earlier levels. For all the fuss made over the costs of war in Iraq and Afghanistan, defense outlays rose to a high of only 3.8% of GDP during that time and remained an historically small 20.1% of the budget. But even in the face of this gradual downtrend, it stretches credulity to expect the projected budgeted declines. Both past norms and geopolitical pressures conservatively point to spending about 0.5 percentage points of GDP higher than the White House projects in its budget, bringing it closer to 3.1% of GDP than the official 2.6% projection for 2019.</p>
<p>White House expectations on entitlements spending are even less consistent with historical trends than are its expectations on defense. This broad category includes outlays on Social Security, Medicare, Medicaid, unemployment insurance, an array of smaller programs, and, looking forward, outlays required by the Affordable Care Act. Throughout this long history, spending on these items consistently has outpaced both the rest of the budget and the growth of GDP. At the end of World War II, for example, entitlements obligations about equaled defense spending, amounting to 3.4% of GDP and about 30.4% of the budget. By 1975, they had risen to almost 10.0% of GDP and almost half of all federal outlays—almost twice defense spending at the time. By the end of the century, such outlays were three times the size of the defense budget, amounting to about 60% of all federal spending and almost 11% of GDP. Even as the Iraq War shifted budget priorities, entitlements spending continued to rise faster than the economy, so that they now account for about 70% of all federal spending and just less than 15% of GDP—more than four times defense spending. In contradiction to these powerful trends, the White House projects little further relative growth to 2019—a dubiously optimistic outlook given this history and certainly anticipating the outlays connected to the Affordable Care Act.</p>
<p><b>Interest &nbsp; &nbsp; &nbsp;<br>
</b>On both these important counts, then, the White House spending estimates look low. Since combined defense and entitlements amount to almost 90% of all federal spending, their patterns effectively say it all for overall spending, which, given these observations, will likely end up absorbing two-plus percentage points more GDP than the White House suggests. On this basis, the economic burden of the federal government by 2019 would easily approach the high of 24.4% of GDP recorded during the 2009 economic emergency. But there is another element in the equation that might push up the figure even higher, and that is interest expense on the outstanding debt.</p>
<p>In recent decades, interest expenses have tended to rise relentlessly because chronic deficits have added, equally relentlessly, to outstanding debt loads. Up until the late 1970s, however, manageable deficits and contained rises in interest rates kept these expenses from rising too much faster than GDP. In 1976, for instance, interest expenses amounted to only 1.5% of GDP and 7.2% of all federal spending. But by the early 1980s, expanding deficits and a spike in interest rates raised interest expenses briefly to more than 3.0% of GDP, and brought them up to fully 14.0% of all federal spending at the time. In the 1990s and earlier in this century, falling interest rates and more moderate deficits allowed this relative expense to fall toward 1.7% of GDP by 2007. Despite huge deficits since then, very low interest rates have actually pushed down this expense item. In 2014, outlays for interest will likely amount to only 0.8% of GDP (6.1% of all federal spending.) Looking forward, however, it is apparent that this relief cannot last. Deficits, though reduced from a few years ago, remain historically large, and rates, if the Federal Reserve is to be believed, are scheduled to rise.</p>
<p>Anticipating this effect, the White House’s interest-rate projections are not unreasonable. The president’s budget assumes that 91-day Treasury bill rates will rise from about zero today to 1.2% on average in 2016 and 3.6% by 2019. It projects that 10-year Treasury note yields will rise 140 basis points from present levels, to 4.0% by 2016 and another 70 basis points to 4.7% in 2019. These increases push projected interest expenses from 1.7 percentage points of GDP to 2.5% by 2019 (11.6% of all federal outlays.) Of course, if other considerations—on defense and entitlements—turn out anywhere near accurate, deficits also will rise higher than the president’s budget projections, raising interest expenses more than expected in the budget, even if the White House has made an accurate interest rate forecast. On this basis, the expense from interest will likely rise to approach the 3.0% it averaged in the 1990s. Adding this difference into the mix should easily bring the overall economic burden of the federal government above the 2009 record of 24.4%.</p>
<p><b>A Qualitative Conclusion<br>
</b>For all the number crunching, either here or by the White House, it bears saying that such figuring is always slippery, especially five years out. But if the exercise cannot bear the precision people would like, there are at least three inescapable conclusions to draw from this work:</p>
<p>&nbsp;&nbsp;&nbsp;&nbsp;1)&nbsp;&nbsp;Unless Washington turns away from more than 60 years of precedent and engages in entitlements reform, the relentless demands of these programs, already more than 70% of the entire budget, will burden the economy increasingly and dominate the budget still more going forward, squeezing out other government priorities.</p>
<p>&nbsp;&nbsp;&nbsp;&nbsp;2)&nbsp;&nbsp;At one time, defense spending was large enough so that cuts there could offset the overall effect of the ever-growing entitlements expense. Because the Pentagon has fallen as a portion of the budget, savings there no longer offer the leverage on overall spending they once did, even if cuts were feasible, which, with the growth of global tensions, they are not.&nbsp;</p>
<p>&nbsp;&nbsp;&nbsp;&nbsp;3) &nbsp;With the inevitable rise in interest expense on top of these effects, Washington will lose almost all flexibility with the rest of the budget. The programs that the election campaigns will describe and promise will be a chimera, in particular the plans for infrastructure refurbishing and research and development that make a regular return to prominence with each election cycle.&nbsp;</p>
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Mon, 27 Oct 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/life-cycle-or-lifestyle-fund-a-critical-investment-decision.htmlA Life-Cycle or Lifestyle Fund? A Critical Investment Decision<div class="everything">
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<h3><i>Just because two people are the same age does not mean that they have the same investment needs or risk tolerances.&nbsp;&nbsp;</i></h3>
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<p>The research is plain: Participants in 401(k) plans and retail investors generally seem determined to simplify their investment decision making. They have shown a preference for funds that diversify over a number of investment classes, managing, in a single purchase, to buy a mix of needed assets. There are a great variety of such funds, but they tend to come in two basic types: 1) those structured to the investors’ life cycle and 2) those structured to meet specific investor objectives and risk tolerances. The former, the life-cycle approach, is dominated by age-based funds. These combine assets—stocks, bonds, international investments, etc.—according to a set schedule based on the investor’s age and nearness to retirement. The latter, often called lifestyle or risk-based funds, aim to satisfy specific investment objectives and needs regardless of the investor’s age or nearness of retirement. While the life-cycle approach works for many, it carries certain rigidities that recommend the more flexible and individualized lifestyle approach.</p>
<p><b>The Issue of Individuality<br>
</b>Individuality is a critical consideration. Just because two people are the same age does not mean that they have the same investment needs or risk tolerances. A 38-year-old who has saved regularly for the prior 15 years has very different investment needs than another 38-year-old who has had some false starts in his career and has done very little saving. The late starter might want to make up for lost time and, accordingly, likely will seek a more aggressive investment portfolio than the first investor, who might well see a greater need to protect his nest egg and so prefer a more conservative approach. Despite such differences, life-cycle funds, guiding off age alone, treat these two investors in exactly the same way.&nbsp; Each might do better drawing in an array of lifestyle funds, with one opting for a more conservative and the other for a more aggressive asset mix.</p>
<p><b>The Issue of Flexibility<br>
</b>Yet life-cycle funds can rarely cope with life’s inevitable surprises. A divorce at 50, for example, might severely deplete what seemed like a secure investment nest egg, leaving its owner, despite his or her age, with a need to rebuild his or her asset base and, consequently, a concomitant need to take an aggressive investment posture. On the opposite side of the scale, a large inheritance at 40 might alter a person’s asset base sufficiently to turn all previous strategies on their head. An unexpected child or other dependant could similarly disrupt a person’s financial plans so that the prescribed age-based mix might not apply, might even suddenly seem counterproductive. Very unlike the life-cycle or age-based approach, an array of lifestyle funds would allow the investor to adjust strategy in response to such changes.</p>
<p><b>Post-Retirement Issues<br>
</b>Other problems with life-cycle funds can arise even after retirement. Unlike past generations, people retiring today plan to live for many years. At 65 years of age, for instance, the U.S. Census Bureau estimates in excess of 20 years of reasonable life expectancy. Over such an extended period, any investment should at least partially protect its owner from the ravages of inflation. Since many life-cycle funds roll assets into an annuity at the time of retirement, they may fail to offer such protections. A lifestyle approach, carefully selected, can, however, provide a measure of needed inflation protection over the years of retirement.</p>
<p><b>A Coincidence of Interests<br>
</b>In one other important respect, it is bewildering why any financial advisor would recommend a life-cycle or age-based investment. Because the approach effectively locks the investor into a preset schedule, the decision blocks any room for additional advice and so, in effect, puts the advisor out of a job. Beyond the selfish motives of an advisor, it also should be clear that there is good reason, from a client’s viewpoint, to pause before rolling into a life-cycle or age-based approach, with its lack of individuality and flexibility, and consider lifestyle funds in its place.</p>
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Mon, 20 Oct 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/europe-draghis-deflation-desperation.htmlEurope: Draghi's Deflation Desperation<div class="everything">
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<h3><i>The specter of falling prices in the eurozone is making the ECB chief’s job even harder.</i><b></b></h3>
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<p>The European Central Bank (ECB) faces a desperate situation. Remarkably low inflation is stealing its ability to ease the eurozone’s fiscal-financial strains and, consequently, its ability to buy time for the zone’s governments to implement desperately needed budgetary and economic reforms. If markets do not show it yet, the pressure of this crisis is intensifying on every front.</p>
<p><b>The Problem and the Bank’s Response &nbsp; &nbsp;&nbsp;<br>
</b>Economic reports from the eurozone are universally ugly. Germany’s economy, until now the major source of strength in the eurozone, declined during the second quarter. The Italian economy also declined. France, the zone’s second largest economy, has stagnated. Perhaps even more threatening than the prospect of a generalized recession are the inflation figures. Zone-wide prices have risen a mere 0.3% during the past 12 months, far below the 2.0% ideal identified by the ECB and perilously close to deflation, a frightening condition widely associated with Japan’s more than two decades of economic decline.<sup> 1</sup>&nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Beyond such vague associations, deflation threatens a concrete policy problem. An element of inflation was always an essential part of the ECB’s efforts to resolve the crisis. Because rising price levels reduced the real value of outstanding debt, they put time on the side of relief. Outright deflation would actually make it an enemy by raising the real value of outstanding debt. Inflation also helped reduce real financing costs. Two years ago, for instance, zone-wide inflation of 2.5% cut that amount annually off the real burden of interest expenses. Combined with the then prevailing 1.5% benchmark short-term interest rate, this inflation effect actually took real financing costs into negative territory, to -1.0%, in fact. Now, though the ECB has decreased the benchmark interest rate to only 0.05%, inflation of only 0.3% does that much less to ease real financing costs, which, though still negative, have risen 0.75 percentage points to -0.25%. It is as if the ECB had tightened monetary policy.<sup>2</sup>&nbsp; &nbsp;&nbsp;</p>
<p>Well aware of their predicament, policymakers at the ECB have turned to unconventional means in what looks like a desperate effort to continue some level of financial relief. Near zero-rate policies are themselves indicative, especially since the ECB until recently resisted such policies. The bank also has decided to stop paying commercial banks interest on reserves left idle with it and has begun to <i>charge</i> them, recently raising that cost to 0.2% a year. This novel, negative rate policy, they no doubt hope, will spur commercial banks to use their idle reserves for lending, stimulate economic activity, and help block any drift toward deflation. It might work, but it is hardly in the character of the old, conservative ECB. Still more, ECB president Mario Draghi announced that the bank would earmark close to €500 billion to buy asset-backed bonds in European financial markets and so channel funds directly to borrowers, again to stimulate economic activity and generate inflation instead of deflation. This quantitative easing, too, was something the bank had resisted. It speaks to how far the ECB has come, and to its desperation, that Germany’s Bundesbank has overtly criticized these policies.<sup>3</sup></p>
<p><b>Deeper Problems</b>&nbsp;<br>
Matters are that much more intense because few governments have used the past relief bought for them by the ECB to do much of anything to make their economies more dynamic, efficient, and competitive. It speaks to this problem that the deflationary threat itself has roots in the failure to reform. Had they proceeded with the kinds of changes pressed on them by the ECB and Germany, they would have long since dispensed with the subsidies they use to prop up inefficient and unprofitable operations and used the savings to offer tax relief to effective producers. But the taxes remain high, and these props remain in place. These unprofitable operations have, accordingly, glutted markets and driven down prices. Italy, for instance, has kept open a large Sicilian oil refinery even though it has accumulated €10 billion in operating losses during the last five years and the country uses 30% less gasoline than it did eight years ago. France and Italy have used subsidies to keep open 18 auto plants that also run losses. Italy still provides tax subsidies to keep open factories producing household appliance that the Swedish owner, Electrolux, has identified as unprofitable.<sup>4</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>The picture looks bleak. Things seem poised to fly apart at any moment. They may well hold together for longer than seems possible, if only because people want them to do so. If Europe’s periphery now uses the remaining breathing room offered by the ECB’s redoubled efforts and implements needed reforms, this can yet work out. If, as it seems, these governments are determined to waste the opportunity, the eurozone looks scheduled for renewed upheaval.&nbsp;</p>
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Mon, 13 Oct 2014 09:55:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/stocks-priced-to-correction.htmlStocks: Priced to Correction?<div class="everything">
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<h3><i>Some market observers are worried that equities are overvalued and that a pullback is imminent. They shouldn’t be.&nbsp;</i></h3>
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<p>A short news item that reported marked improvement in retail investor sentiment seems to have created bearish feelings among several financial advisors. Helped by a pessimistic write-up in <i>Market Watch</i>’s<i> </i>“The Tell” column,<sup>1</sup> many took the news as a sign that stocks are overbought and so vulnerable to a correction. Equities, of course, are always vulnerable to correction, but a broader look, at the sentiment index<sup>2</sup> itself as well as most other indicators, belies this facile negative interpretation. On the contrary, equity valuations and prospects for continued, if slow, earnings growth suggest that the general equity rally should continue, albeit not at last year’s impressive pace.&nbsp;</p>
<p>The reports that seem to have created this misplaced bearishness came out of the American Association of Individual Investors. Its sentiment index showed a nearly 40% jump in bullish feeling among retail investors as summer turned to fall. That has taken the index higher than it has averaged all year and higher than it averaged through much of 2013. Since enthusiasm about stocks tends to push up prices, often beyond the fundamentals, the concern, expressed in the column and by those financial advisors who have embraced its negative view, is entirely understandable. But before allowing a few data points to swing opinion, much less guide investment decisions, people, whether journalists or financial advisors, need to test such signals against other benchmarks. &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>Compared with its own recent past, this sentiment figure would hardly seem to signal danger. Though up, it is, after all, 10% below where it was briefly early in 2013.<sup>3</sup> Certainly, these higher figures hardly stopped equities from doing quite well. What is more, this recent sentiment figure is more than 13% below levels recorded late in 2010, and though equities have shown a lot of volatility since, they have risen impressively on balance. On these bases alone, investors have little reason to fear the recent uptick in bullish sentiment. On the contrary, it might actually help push up equities by freeing still substantial holdings of idle cash.&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>In the meantime, equity valuations still look attractive. Even with the upward price moves of recent years, earnings multiples today are hardly elevated from an historical perspective. They are, in fact, little different from their long-term averages, suggesting that even the most cautious investor would identify stocks as fairly valued, at worst, and so capable of at least tracking earnings, which are likely to rise even in this slow-growing economy. Relative to bonds and cash, stocks look better than fairly valued. This is no place to work through all the various metrics used in such comparisons, but they all tell pretty much the same story, one that is most easily outlined through a comparison of dividend yields and interest rates on cash. Today, cash pays little more than zero, while the S&amp;P 500<sup>®</sup> Index,<sup>4</sup> even after past gains, still pays a dividend yield of close to 2.0%. Historically, cash offers two percentage points <i>more</i> than the dividend yield on stocks, not the nearly 2.0% <i>less</i> it does now.<sup>5</sup>&nbsp;This tremendous difference from past patterns suggests not only that equities remain attractively valued but also that they can absorb a rise in interest rates before valuations even approach historical norms. &nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>On this basis, stocks would seem capable of increasing their multiples going forward and outpacing earnings. But even if multiples remain steady, this bearish worry is misplaced. To be sure, this slow recovery will keep earnings growth contained. Domestic revenues over the next 12 months, for instance, should about track the likely 4.5% rate of expansion in the nominal gross domestic product (GDP).<sup>6</sup>&nbsp;Since most of the corporations in the S&amp;P 500 earn a substantial amount overseas, many in emerging markets, overall revenues should outpace this figure slightly, bringing gross revenues up about 5–5.5%. With little pressure up or down on margins, gross earnings should rise at about this rate. Share buybacks, however, should push the per-share figure up faster. Presently, buybacks are running at a yearly rate of 2.5% of outstanding shares. Against that are exercised options and initial public offerings (IPOs). A reasonable net effect would likely reduce shares outstanding by some 0.5–1.0% over the next 12 months, bringing the per-share earnings growth to about 6.0%. With prices in a fairly valued market appreciating in tandem, investors, with the addition of the 2.0% dividend yield, could conservatively look for an 8.0% overall return from equities—not bad compared to investment alternatives and possibly better if still attractive valuations support a rise in multiples. &nbsp;</p>
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<p><span class="legal"><sup>1</sup>&nbsp;William Watts, “Unloved No More?” Market Watch, August, 21, 2014.<br>
<sup>2</sup>&nbsp;American Association of Individuals Investors Sentiment Survey, September 24, 2014<br>
<sup>3</sup>&nbsp;Ibid.<br>
<sup>4</sup>The S&amp;P 500<sup>®</sup>&nbsp;Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. Indexes<b></b>are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.<b>&nbsp;</b><b>Past performance is no guarantee of future results.<br>
</b><sup>5</sup>&nbsp;Data from Standard &amp; Poor’s.<br>
<sup>6</sup>&nbsp;Data from Federal Reserve.</span></p>
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Mon, 6 Oct 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/how-might-stocks-take-a-hike.htmlHow Might Stocks Take a Hike?<div class="everything">
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<h3><i>Here's a look at what happened to equities during past periods when the Fed raised rates.&nbsp;</i></h3>
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<p>Though the Federal Reserve continues to show extreme caution about rate increases, the expectation is that policy will move in that direction sometime next year. This prospect prompts a look here at how stocks have behaved during past such interest-rate moves and, by implication, how they might behave this next time. As is so often the case, the historical record is far from clear. Still, the patterns that do exist, amid other indicators, suggest little reason to abandon equities in anticipation of such a move, and within stocks, also suggest a bias toward growth and more economically sensitive sectors.</p>
<p><b>When Rates Rose<br>
</b>The available data permit a look at six times in the past when the Fed permitted a significant up move in short-term rates. Table 1 outlines these:</p>
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<p><b><span class="rte_txt_green">Table 1. Federal Reserve Rate Hikes</span></b></p>
<table class=no_style border="1" cellspacing="0" cellpadding="2" width="570">
<tbody><tr><td width="186" valign="top"><p><b><br>
<br>
Periods of Increase</b></p>
</td>
<td width="84" valign="top"><p><b><br>
<br>
Low Rate</b></p>
</td>
<td width="90" valign="top"><p><b><br>
<br>
High Rate</b></p>
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<td width="108" valign="top"><p><b><br>
Total Move<br>
(basis points)</b></p>
</td>
<td width="150" valign="top"><p><b>Monthly, <br>
Rate of Increase<br>
(basis points)</b></p>
</td>
</tr><tr><td width="186" valign="top"><p><b>1.&nbsp; Mar. 1972–Aug. 1974</b></p>
</td>
<td width="84" valign="top"><p>3.72%</p>
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<td width="90" valign="top"><p>8.75%</p>
</td>
<td width="108" valign="top"><p>503bps</p>
</td>
<td width="150" valign="top"><p>21 bps</p>
</td>
</tr><tr><td width="186" valign="top"><p><b>2.&nbsp; April 1977–May 1981</b></p>
</td>
<td width="84" valign="top"><p>4.54</p>
</td>
<td width="90" valign="top"><p>16.29</p>
</td>
<td width="108" valign="top"><p>1075bps</p>
</td>
<td width="150" valign="top"><p>22 bps</p>
</td>
</tr><tr><td width="186" valign="top"><p><b>3.&nbsp; Oct. 1986–Mar. 1989</b></p>
</td>
<td width="84" valign="top"><p>5.18</p>
</td>
<td width="90" valign="top"><p>8.83</p>
</td>
<td width="108" valign="top"><p>365bps</p>
</td>
<td width="150" valign="top"><p>13 bps</p>
</td>
</tr><tr><td width="186" valign="top"><p><b>4.&nbsp; Sept. 1993–Jan. 1995</b></p>
</td>
<td width="84" valign="top"><p>2.96</p>
</td>
<td width="90" valign="top"><p>5.81</p>
</td>
<td width="108" valign="top"><p>285bps</p>
</td>
<td width="150" valign="top"><p>18 bps</p>
</td>
</tr><tr><td width="186" valign="top"><p><b>5.&nbsp; Oct. 1998–May 2000</b></p>
</td>
<td width="84" valign="top"><p>4.04</p>
</td>
<td width="90" valign="top"><p>5.92</p>
</td>
<td width="108" valign="top"><p>184bps</p>
</td>
<td width="150" valign="top"><p>10 bps</p>
</td>
</tr><tr><td width="186" valign="top"><p><b>6.&nbsp; Jan. 2004–Feb. 2007</b></p>
</td>
<td width="84" valign="top"><p>0.88</p>
</td>
<td width="90" valign="top"><p>5.03</p>
</td>
<td width="108" valign="top"><p>415bps</p>
</td>
<td width="150" valign="top"><p>11 bps</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Federal Reserve Board. A basis point is 1/100 of a percent.</span></p>
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<p><b>Overall Market &nbsp; &nbsp; &nbsp; &nbsp;<br>
</b>If this history is any guide, the prospect of rising rates should hold no fear for equity investors, at least not initially. Though stocks (as measured by the S&amp;P 500<sup>®</sup> Index<sup>1</sup>) often suffer a sharp drop when rates first begin to rise, such setbacks usually dissipate quickly, no doubt because the Fed tends to push up rates when the economy and earnings are growing. The figures vary so much from one instance to the next that averages would be meaningless. But it is well documented that stocks in the past have provided positive total returns on balance for at least four quarters or more after rates begin to rise (other time periods may have been negative). The danger for equities emerges later in the Fed’s tightening phase, no doubt because economic weakness and often recession typically result from the <i>cumulative</i> effect of the increases. Two of these six instances offer an even more encouraging exception. In the late 1980s and early 1990s, the up moves in equities persisted on balance throughout the period of rising rates.<sup>2</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>If this record applies to the future—and there is every reason to believe it may—equities still have room to advance even as the Fed enacts its policy change. Reinforcing this expectation are the still-attractive valuations offered by equities and the prospect that economic growth, and so too earnings growth, though slow, should continue. In contemplating this likelihood of stock gains even after the Fed begins to raise rates, investors also would do well to remember that, according to the Fed’s own statements, the policy change likely will not begin until next year, leaving potentially more room for gains in the interim. &nbsp; &nbsp;</p>
<p><b>Allocation Among Equities<br>
</b>When it comes to decisions on style, the historical picture offers little guidance, at least on the surface. Value stocks outperformed growth stocks in the first three of these periods of rate increases, while growth outperformed value during the two instances of rising rates in the 1990s. In the most recent period of rate increase, between 2004 and 2007, value again outperformed growth. While this seems like a truly mixed bag, a look at what else was happening during these periods can provide some sense of order and also a reason that growth has the potential to outperform during this next round of rate increases. <i>[Although due to market volatility, the market may not perform in a similar manner in the future.]</i>&nbsp; In the 1970s, for example, inflation was an overriding consideration and with it a concern over the quality of earnings that drove investors to favor value over growth. In the first decade of this century, memories of the great tech and dot-com crash created a clear preference for value. Since neither of these matters seems likely to prevail this next time, growth would seem to benefit, especially since valuations now actually favor growth stocks.</p>
<p>This record is hardly conclusive on questions of whether to favor small cap or large cap stocks. In the early 1970s, large caps outperformed small caps as rates rose, but in the late 1970s and 1980s, it was the other way around. During the period of rate increase in the early 1990s, large took the lead, but small bested in the late 1990s—hardly a surprise in the tech and dot-com craze that dominated the time. During the one period of rate increase in this century so far, small outperformed large. Given this less than conclusive picture, it would seem, then, that the best way to proceed is to achieve a broad diversification across capitalization ranges. Fairly consistent valuations across classes argue the same way.&nbsp;</p>
<p>Sector mix, too, presents a muddled historical picture, at least on the surface. In these past periods of increasing rates, no one major industry either leads or lags. That fact should hardly surprise, given how many other influences on relative sector performance operate, whether in periods of rate increase or decrease.&nbsp;</p>
<p>So, for example, technology was the best performing sector during the two periods when rates rose in the 1990s. It also was the best performing sector during the periods of rate decline in the 1990s. Unsurprisingly, technology performed relatively poorly during the only period of rate increase so far in this century, no doubt as a reaction to the tech bust of 2000–02. While technology did its lead and lag, utilities, which would seem to be the anti-tech sector, did surprisingly well during the period of rate increase in the late 1990s, but fell, even as other stocks rose, during the time when rates rose in the early 1990s. Even financials, seemingly most closely associated with interest rates, have shown an inconsistent performance record. They were, for instance, the second worst performing major sector during the period of rate increase in the early 1990s, but were right in the middle of the pack during the period of the rate increase in the late 1990s and during the period of rate increase from 2004 to 2007.&nbsp;</p>
<p>Extrapolating from such a muddle of specifics, it would seem that more economically sensitive sectors have done better in these past periods of rate increase than have other sectors. This stands to reason, since the Fed tends to raise rates when the economy is expanding. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p><b>The Inevitable Bullet Points<br>
</b>From this historical analysis, it would seem, then, that investors, contemplating the Fed’s decision to begin raising rates some months from now, should be guided by these evident patterns:</p>
<p>&nbsp;&nbsp;&nbsp;&nbsp;1. Equities have potential room to move up well into the period of increasing rate hikes.<br>
&nbsp;&nbsp;&nbsp;&nbsp;2. Chances are that growth stocks could lead value stocks into the period of rate increase.<br>
&nbsp;&nbsp;&nbsp;&nbsp;3. Capitalization is such an open question that it calls for a broad diversification on this count.<br>
&nbsp;&nbsp;&nbsp;&nbsp;4. If it is impossible to pinpoint sector winners and losers from past periods of rate increases, the record would seem to favor those that are economically sensitive.</p>
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Mon, 29 Sep 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-budget-the-good-the-bad-and-the-ugly.htmlU.S. Budget: The Good, the Bad, and the Ugly<div class="everything">
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<h3><i>A report from the Congressional Budget Office forecasts shrinking deficits through 2015. After that, fiscal strains begin to emerge.</i></h3>
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<p>The Congressional Budget Office (CBO) has had another look at federal finances. Its forecast, though mostly a technical exercise, has nonetheless made clear the underlying budget difficulties facing this country. It tells of some short-term good news, such as shrinking deficits into 2015. It also highlights that over the longer term the country will have to engage in major entitlements reform or else it will not be able to avoid counterproductive tax hikes, expanding deficits, a squeeze on other aspects of the budget, or some combination of these ugly alternatives.&nbsp;</p>
<p><b>The Immediate Outlook Looks Fairly Good</b><br>
It appears, however, that the next 18 months likely will enjoy financial improvement. The CBO, relying on reasonable economic projections, looks for the federal budget deficit to shrink, from $680 billion in 2013 to $506 billion this year, to $469 billion in 2015—for a net decline of 31% over the next two years. Relative to the gross domestic product (GDP), this anticipated flow of red ink constitutes a major decline in the deficit, from 10.0% of the overall economy in 2009 and the 4.1% in 2013 to only 2.6% in 2015—lower even than the 3.1% of GDP the deficit has averaged over the last 40 years.<sup>1</sup> It is indeed an impressive improvement. &nbsp;&nbsp;</p>
<p>Part of this picture reflects the CBO’s expectation of an annualized growth of 8.7% in revenues over 2014 and 2015. Though the CBO forecasts only 2.4% real economic growth a year and 1.7% inflation, revenues tend to outpace the nominal economy. Aside from the tax hikes, there are two other reasons: 1) the progressive tax code takes on average proportionally more from each additional dollar of personal income and 2) the farther the economy gets from the recessionary years, the fewer firms have past losses to write against their tax obligations. Accordingly, the CBO projects individual income tax receipts to rise 7.7% a year over the two-year period and corporate tax receipts to increase at a 19.2% rate. Payroll taxes, which otherwise miss either of these leveraged effects, nonetheless show a relatively strong 6.0% annual growth rate largely because a partial payroll tax holiday ended at the start of this year. &nbsp; &nbsp; &nbsp;</p>
<p>The expected deficit decline also emerges from slower growth in outlays. The CBO projects an expansion of only 4.2% a year for the two years.&nbsp; Much reflects an expected 2.3% drop in defense outlays. Mandatory programs (as the CBO calls social spending)—such as Social Security, Medicare, Medicaid, the Affordable Care Act—will, the CBO expects, expand at an annual rate of 4.0%.&nbsp; An 11.3% annualized expansion in Medicaid, itself driven by the implementation of the Affordable Care Act, and a 4.8% annualized advance in outlays for Social Security are offset by a slowdown in outlays for income security programs—food stamps, welfare, unemployment, and related activities—to 4.4% a year. Here, the biggest difference comes from declines in unemployment compensation (down at about a 27% annualized rate) due in part to declines in the number of unemployed, but mostly because of the expiration of extended benefits starting in 2014.&nbsp;</p>
<p><b>The Bad News Comes after 2015 &nbsp;</b><br>
In contrast to this rosy picture, the CBO sees things deteriorating after 2015. Flows of red ink, it forecasts, will expand to $560 billion by 2018 and then go to $960 billion by 2024, an increase of 8.2% a year after 2015. Even in an expanding economy, that deficit growth will take the budget shortfall from 2.6% of GDP in 2015 to 3.6% in 2024. Though this CBO estimate is reasonable, these figures actually lean toward the optimistic side in large part because the office’s analysts assume that the economy avoids recession over that entire long stretch of time. Still, the CBO’s forecast of 2.4% a year real growth is far from overly optimistic. It is, in fact, lower than the long-term historical trend of more than 3.0% real growth a year on average.&nbsp;</p>
<p>On this economic base, the CBO’s forecasts moderate revenues growth of 4.4% a year on average. It projects individual income tax receipts will grow at a 5.6% yearly rate, payroll taxes at a 4.1% rate, and corporate taxes at a 2.6% rate. Tax reform could, of course, change these figures radically, but the CBO, as a matter of policy, works on the assumption that the law remains steady over the entire forecasting horizon. It is, admittedly, an unrealistic assumption, but probably the only practical way to proceed, since potential changes are impossible to predict and including possibilities multiplies the potential outcomes infinitely.</p>
<p>However one might cavil over the revenues projections, it is the outlays projections that cause the underlying deficit problem. The CBO expects so-called mandatory programs to rise at an annual rate of 5.1%. A portion of this rapid growth reflects the reasonable expectation that healthcare costs will rise.&nbsp; The lion’s share reflects the growing average age of the population that will enlarge Social Security rolls and multiply spending for Medicare. This longer period will, the CBO expects, experience an acceleration of outlays growth due to the full implementation of the Affordable Care Act, or, in the report’s words, the “expansion in federal healthcare programs.”&nbsp;</p>
<p>The other spending pressure comes from rising financing costs. The CBO expects these to rise 13.7% a year over this longer period. To some extent, this surge reflects the cumulative effect of ongoing deficits on federal debt outstanding, but mostly it reflects the expectation that interest rates will rise.&nbsp; Because the Fed has made it clear that it will begin to raise rates only in 2015, this financing cost consideration has little impact in the near term. The longer term, however, is a different matter. The CBO anticipates that three-month Treasury bill rates will rise from nearly zero now to about 1.1% in 2016, to 3.5% by 2019, and then stay at that level for the remainder of the forecast horizon. It assumes that the 10-year Treasury yield will rise to 3.8% by 2019, where it likely will stay thereafter.</p>
<p><b>The Crux of the Problem</b><br>
Because both these major spending streams—social programs and interest costs—grow faster than revenues, the longer-term financial picture is unavoidably strained. The country, then, will engage in major entitlements reform or it will accept more burdensome taxes or larger deficits or Washington will squeeze the rest of the budget unmercifully. Even with the CBO assumption that defense spending grows at only 2.2% a year after 2015 and non-defense discretionary spending grows at an even slower pace, the deficits increase as a percentage of GDP. If the country faces a war, even a contained one, or wants to upgrade its infrastructure, the pressure will be that much greater. Since neither higher taxes nor entitlements reform looks likely, the prospects outlined so well by the CBO would seem to describe an absolute best-case deficit picture.</p>
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Mon, 22 Sep 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-housing-inspecting-the-recovery.htmlU.S. Housing: Inspecting the Recovery<div class="everything">
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<h3><i>Recent data give the impression of a rapid rebound in the sector, but a deeper look at the numbers suggests a more modest upturn.</i><i></i></h3>
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<p style="font-size: 12px;">July brought signs of a surge in housing. There is a good chance now that Wall Street, and many official bodies in Washington, will run with the numbers and forecast a stronger recovery than previously. They frequently do run with the most recent set of data. But, as is the case almost as frequently, they would make a mistake to do so now. Apart from the tendency of the data to vary randomly from month to month, the underlying housing situation suggests that such strength will fade and will instead conform to the slower pace of recovery otherwise evident in the unfolding cyclical trends.</p>
<p><b style="font-size: 12px;">Most of the Recent Releases Do Look Strong<br>
</b><span style="font-size: 12px;">If the numbers were not universally strong, on balance they surely surprised on the high side. The Commerce Department reported that new housing starts jumped a remarkable 15.7% in July alone.</span>&nbsp;<span style="font-size: 12px;">That is 475.4% at an annual rate, clearly unsustainable. Permits issued for new houses rose 8.6% for the month. Sales of new homes fell 2.4% in July, but they had already seen a tremendous surge earlier in spring that had taken them up at a 20.2% annual rate. Meanwhile, the National Association of Realtors (NAR) indicated a 2.4% jump in the sales of existing homes in July, 32.9% at an annual rate. The popular Case-Shiller housing price index arrives with too much of a lag to have much relevance for such a current accounting, but the NAR, reporting on a more timely schedule, indicates that prices for existing homes rose at a 5.0% annual rate between June and July. This figure is also entirely consistent with the 5.0% home price advance over the past year. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</span></p>
<p style="font-size: 12px;">The detail in these reports was short of universally upbeat, but generally it, too, confirmed the picture of strength. Starts of new homes were particularly strong in multi-unit structures, rising 33.0% in July. Builders broke ground on 8.3% more single-family structures in the month, an impressive figure by itself.&nbsp; Permits issued in July for future construction were a bit less impressive, but still upbeat. Those for multi-family units rose 23.6%, and permits to build single-family units rose at an 11.3% annual rate. And the increases were pretty much across all regions of the country. The best showing was for starts of single-family structures in the Northeast. These rose an astounding 44.0% from one month to the next, also clearly unsustainable. Only the Midwest showed a decline, but that came after a surge in June that saw a 12.5% jump in starts and a 7.8% jump in permits. Sales of existing homes were equally widespread. &nbsp;</p>
<p style="font-size: 12px;"><b>Not as Good as It Looks &nbsp;<br>
</b>It would premise quite an acceleration in the recovery if such trends were to persist. It also would add an element of fear, since such a breakneck pace of construction would soon lead to excesses and then to a difficult correction. But neither the promise nor the fear is well placed. These recent figures have much that is transitory about them, and the fundamentals point to a much slower pace of advance.</p>
<p style="font-size: 12px;">There are still elements, even in these July figures, of catch-up from the setbacks imposed by an inordinately severe winter weather earlier in the year. Because of the winter setback, housing starts in June were still almost 9% below their level of the previous December. It is only natural, then, that July would experience a surge as builders try to regain the lost ground. Similarly, sales of existing homes had fallen at an almost 12.5% annual rate between last December and last April, leaving ample room for an above-trend recovery into July. This pattern may well continue for another month or two, but once the down/up ride imposed by weather passes, the less impressive underlying trend should prevail. And here there is good reason to expect only a modest uptrend in sales and perhaps even a correction in starts.&nbsp;</p>
<p style="font-size: 12px;"><b>Reason to Look for a More Modest Advance<br>
</b>Crucial is the slow pace of family formation. Housing sales invariably and closely follow family formation. The problem today is the slow pace of jobs growth in this recovery. Though net payroll expansion has picked up late, to more than a 200,000 monthly rate, that figure still trails the standard of past recoveries, when net payrolls grew by more than 300,000 a month. With jobs relatively scarce, especially good-paying, full-time positions, people are delaying that crucial step to form a family that, historically, leads to home purchases. Of late, the Census Bureau estimates net household formation has averaged some 300,000 a year, a far cry from the 1.7 million averaged earlier in the century. With little room to expect a pickup in jobs growth (see <i>Economic Insights, </i>“<a href="/content/lordabbett/en/perspectives/economicinsights/jobs-recovery-half-speed-ahead.html">Jobs Recovery: Half Speed Ahead</a>,” July 28, 2014), it is unlikely that family formation will accelerate markedly and, so, also sales of either new or existing homes.</p>
<p style="font-size: 12px;">Costs and credit also factor into the picture. With mortgage rates up, albeit marginally, and modest advances in real estate prices, home purchases are not as affordable as they once were. The NAR publishes an affordability index. It compares the average household incomes to the cost of supporting a mortgage on the average home. It shows an almost 9.0% drop in affordability from a year ago and an almost 22% drop from the best figures back in 2012. To be sure, housing is still more affordable than at almost any time in the early years of this century or the 1990s, but this recent deterioration should keep a lid on the pace of any future sales growth—so also will the continuing reluctance of lenders. They have of late become easier about lending for residential real estate. Up until this year, they were still cutting back on such loans. But even this year’s expansion shows only a 5.1% annual rate of increase. The ongoing, if slightly less intense caution exhibited by lenders should continue to make it difficult for many potential buyers to get mortgage loans. &nbsp; &nbsp; &nbsp;</p>
<p style="font-size: 12px;">If home sales promise to advance along only a modestly rising path, construction looks primed for a correction. Housing starts rose some 22% during the past 12 months, including the July surge, but sales of new homes have risen only 12.3%, barely over half as fast, while sales of existing homes during the past year have actually fallen slightly. This kind of disparity between construction and sales is not likely to last. Builders are clearly banking on a sales acceleration, either explicitly and implicitly. The inventory of new homes speaks to this bet. As of July, six months’ supply of completed homes stood waiting for buyers, far less, of course, than during the dark days of the housing burst, but 22% more than existed late last year. This figure seems set to expand as builders complete all the starts recorded of late. At some future date, probably this fall or winter, builders may well pause, especially if, as is likely, the growth of sales holds to the expected slow pace. Then construction will likely first fall outright for a month or two and then fall into line with the modest pace of sales growth.</p>
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Mon, 15 Sep 2014 09:45:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-feds-labor-pains.htmlThe Fed's Labor Pains<div class="everything">
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<h3><i>The central bank’s tricky task is to identify the right labor-market signals on which to base its policy decisions.</i></h3>
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<p>Federal Reserve chairwoman Janet Yellen has made it clear in her testimony: monetary policy will respond to the state of labor markets. She also has made it clear that no single jobs measure will move the Fed.<sup>1 </sup>Policymakers will respond to an array of indicators to get a complete picture. Without access to the Fed’s closed meetings or Chairwoman Yellen’s private thoughts, it is impossible to know exactly what mix of indicators the Fed is using or how it is using them, but it is possible to offer perspective on the array of available measures.</p>
<p><b>The Unemployment Rate<br>
</b>The headline unemployment rate receives much attention. It is, however, often misleading, as Yellen pointed out in her recent congressional testimony, though using typically guarded language. The problem with the measure is that it counts only those looking for work as unemployed and then states that count as a percentage of the workforce, those at work plus those looking. If people get frustrated with the search and cease the effort, that hardly speaks well of the labor situation, but they do not count in the calculation. The rate, then, can give a false picture of reality. &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>That certainly is what has happened recently. This official gauge of unemployment has fallen, from 7.3% of the workforce a year ago to 6.2% recently.<sup>2</sup> In this calculation, however, the actual number of people at work or seeking work has barely increased. Since the nation’s working-age population has grown during this time, it seems clear that an increasing number of people have ceased looking for work or, perhaps, decided not to start. Put another way, participation of people in the workforce has dropped, from 63.4% of the civilian population, in fact, to 62.9%. Little wonder, then, that the very modest 1.4% increase in employment had such an outsized influence on the overall unemployment rate. Matters look much different when the Labor Department adds into the calculation those discouraged workers, those working part time for economic reasons, and, in the department’s words, those “marginally attached to the labor force.” After these adjustments, the combined measure of unemployment and underemployment comes to 12.2% of the workforce, down from 13.9% a year ago, but hardly the stuff that would get the Fed to cease worrying over the jobs situation and change policy.</p>
<p><b>Payrolls &nbsp;<br>
</b>This indicator is more stable than the unemployment rate. Aside from the perspective it offers, the Fed no doubt also values it because it is truly independent of the unemployment rate. Whereas the Labor Department develops the unemployment rate from a monthly survey of households, this figure comes from data provided by businesses. The payrolls data are, however, not without flaws. Because it is more difficult to get timely information from small businesses than large, the directions taken by those larger employers tend to dominate current payroll figures. The Labor Department uses estimates to bridge this gap, but these can either overstate or understate reality, especially when employment trends in large and small businesses diverge, which they frequently do. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Payroll data do point to a marginally improved picture. During the past 12 months, net additions to payrolls have averaged 214,000 a month. That is up from 194,300 a month in 2013 and 186,300 in 2012. But such improvements, welcome as they are, are not likely on their own to move the Fed. Its policymakers are well aware how weak even these recent gains look compared with past cyclical recoveries, when payrolls grew typically by more than 300,000 a month, even decades ago when the economy and the labor force were smaller than they are today. The Fed also is well aware that total payroll employment only just recently surpassed its previous peak from six and a half years ago. The Fed knows that past recoveries have made much faster progress than this. Surely, the Fed wants further gains before it is willing to declare labor markets healthy and act on that judgment. No one at the Fed will, of course, say how much net gain will make policymakers comfortable, but it surely exceeds the 0.5% by which most recent total employment figure exceeds that distant past peak.</p>
<p><b>Still More Data &nbsp; &nbsp; &nbsp;<br>
</b>If past Fed commentary is any indicator, monetary policymakers also are concerned about the mix of employment, in particular how much is full time and secure. The Fed will, as a consequence, also likely include in its deliberations a consideration of Labor Department statistics on part-time employment. Here, too, the figures suggest a while before anyone would judge the jobs situation healthy. Part-time jobs today constitute almost 5.5% of all jobs, down from a whopping 6.9% at the depths of the Great Recession in 2008–09, but still a bigger portion of the whole than in any other recovery. Indeed, today’s improved figure is still worse than the worst recorded in most past recessions. In all likelihood, the Fed will want to see considerably more progress here before it moves decisively to change policy. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Other gauges that may well find their way into Fed deliberations include average weekly hours, particularly overtime, especially in concert with weekly earnings. Policymakers know that they must change policy before an inflationary wage momentum takes hold. If they do not, they will have to overcome, not just forestall, a difficult trend. But they also know that weekly wage figures reflect overtime, especially among hourly manufacturing workers who earn time and a half for weekly work above 40 hours. Policymakers will strive to distinguish such wage effects from anything more fundamental and so inflationary. In the past year, as overtime has increased 6.3% and the average workweek overall has increased 0.3%, weekly wages have increased 2.4%. Such a combination of events implies no underlying, inflationary wage pressure. If, however, overtime or the average workweek were to stabilize or drop and weekly wage gains were to accelerate, even modestly, it would signal the Fed that competition for workers was picking up and that policy should perhaps turn in a less supportive direction. &nbsp; &nbsp; &nbsp;</p>
<p><b>A Final Word<br>
</b>No doubt the Fed will rely on still other data points to form its picture of labor markets and determine when they warrant policy modification. This brief review of some likely influences should nonetheless give a sense of the more general picture the Fed has painted of its plans. Its policymakers will avoid a single gauge and instead will weigh one indicator against another, taking account of each measure’s inadequacies to form their picture of labor markets and, from that complex analysis, steer policy.</p>
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Mon, 8 Sep 2014 10:30:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/state-and-local-governments-outpace-the-feds.htmlState and Local Governments Outpace the Feds<div class="everything">
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<h3><i>The fiscal health of state and local governments appears robust when compared with that of the federal government.</i><b></b></h3>
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<p>State and local government finances appear to have stabilized. No one could describe them as sound, in aggregate and certainly not in certain particulars, but they have stabilized in general. The sector as a whole continues to run deficits, of course, and there are many pressure points on the expenditures side of state and local government budgets. But these governments have kept spending growth in line with revenues growth and, so, have contained the flow of red ink. There also is the likelihood of such continued relative stability going forward, even in the country’s slow-growth economic environment. This is good news, even with all the caveats. There are, however, longer-term concerns.</p>
<p><b>A Look at Where We Have Been<br>
</b>State and local government finances have faced a tough pull back from the great recession of 2008–09. Quite apart from the pension issues that have garnered so much media attention, those economic hard times hit state and local budgets from both sides. Revenues fell as the economic downturn dragged down just about every tax line item. Between the fourth quarter of 2007 and the second quarter of 2009, personal income tax receipts fell 7.2%, sales tax receipts fell 7.7%, and corporate tax receipts fell 24.4%. Ironically, given the real estate roots of the recession, the only revenue item to rise was property taxes, which expanded 6.1%, largely because these flows reflected prior strength.<sup>1</sup>&nbsp; &nbsp; &nbsp;</p>
<p>Against this difficult shortfall in receipts, the recession produced outsized demands for spending on social services. State and local outlays in this area jumped 13.8% between the fourth quarter of 2007 and the third quarter of 2009, when this particular pressure began to ease. As a consequence, overall state and local expenditures expanded 10.4% during that time. It is hardly surprising, then, that state and local budget deficits rose, from an annual rate of $205.2 billion in the fourth quarter of 2007 to $377 billion by the middle of 2009, an 83.9% increase that raised the deficit, from 9.4% of total expenditures to 16%.</p>
<p>Following the devastating effects of the recession, the sluggish nature of this recovery has capped the growth of state and local receipts since. Between mid-2009 and the end of 2012, those receipts grew only 10.1%, or a mere 2.8% a year. Like incomes throughout the economy, this pace of expansion barely exceeded inflation. The recovery did, however, enable state and local governments as a whole to regain control of their outlays. Though substandard by historical standards, the pace of economic growth slowed demands for social benefits, keeping growth in this expenditure line item to 2.7% a year. This moderation, plus budget cuts elsewhere, enabled governors, mayors, and local managers to hold the pace of overall spending to a mere 0.8% a year, thereby stemming the tide of red ink, so that by the close of 2012, state and local deficits as a whole equaled $269.1 billion a year, about 10.0% of overall expenditures.</p>
<p>Since then, these governments have eased off a bit on their austerity efforts. Their receipts have continued to grow at the slow 2.8% annual pace they set earlier in the expansion. Because outlays for social benefits have continued to rise faster than revenues—at a 5.9% annual rate in fact—these governments have had to continue squeezing the rest of their budgets to contain the growth in total outlays to 2.5% a year. That figure is faster than earlier in the recovery, but still slow and close enough to revenues growth to have held back the annual flow of red ink, which, as of the first half of 2014, stood at $259.7 billion a year, a touch over 10.0% of total expenditures.</p>
<p><b>Looking Forward &nbsp;<br>
</b>For the time being—a horizon of two to three years—likelihoods favor a continuation of this contained trend. A slow-growing economy should promote some growth in state and local revenues, but, as during the past few years of recovery, not much faster than the rate of inflation. With little sign of an acceleration in the economy, there is little chance of revenue growth exceeding 3.0% by much. At the same time, the limited chance of recession removes much risk of an outright decline in revenues, certainly not on the scale that occurred during 2008–09. Given political pressure to sustain some budget control and concern about how investors would react to widening deficits, governments should also continue to manage the pace of growth in outlays at about the rate of revenues growth, keeping a lid on the growth of red ink to about 10–10.5% of total expenditures. &nbsp;</p>
<p>Though this pattern can last for a while, it is, however, unsustainable over the longer term. Except in the unlikely event that the economy gets a whole lot better quickly, the pace of growth in spending on social benefits will continue to outstrip revenues growth, as it has so far in this sluggish recovery. The recent growth rate of 5.9% is entirely plausible. An improvement in the jobs market, even a modest improvement, would tend to slow the pace, but against that, the further implementation of the Affordable Care Act threatens to add to the figure. The longer this goes on, the harder time state and local governments will have squeezing other parts of their budgets to keep the overall pace of outlays growth in line with revenues. Unless, then, there is some action to address this pressure, state and local finances over the longer term will again come under renewed, severe pressure. &nbsp;</p>
<p>There is another risk for the longer-term outlook, and that is a rise in interest rates. The budget burden of financing has fallen as a part of total outlays, from 8.3% at the end of 2009 to 7.8% recently. Part of the decline reflects the success state and local governments have had keeping a lid on the flow of red ink. Part of it also reflects the remarkably low level of interest rates during this time. Over the long term, however, interest rates are very likely to come under upward pressure. Because municipal yields and rates at present (though low by historical standards) are high relative to Treasury and corporate yields and rates, they likely will resist any initial up move in yields and rates generally. Eventually, however, they will succumb to any general move upward. When that happens, state and local governments will have to pay more for financing, burdening their budgets further. So, unless they can indefinitely squeeze those other parts of their budgets they have shortchanged since this recovery began—a doubtful possibility—their deficits will tend to rise. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p>These pressures seem unavoidable. An economic acceleration could, of course, relieve the strain by accelerating the growth of state and local receipts; but, as indicated, that looks unlikely right now. The budget pressure on this more distant horizon will, doubtlessly, create a concomitant political pressure for further reform in state and local financing. Should that reform prove effective, it could improve finances over the longer term and the security of municipal bond investments with it. A failure to reform over this longer time horizon or ineffective reforms would make matters less secure. Even in this case, however, the fears of investment loss, which surely would accompany such pressure, will almost surely overstate the risk. Since most of these governments know how much future financing depends on a reliable discharge of their debt obligations, they will squeeze a good deal else in their budgets, including social benefits, to avoid reneging on their bond obligations in any way. &nbsp;</p>
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Tue, 2 Sep 2014 13:35:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/stocks-eyeing-the-ipo-boom.htmlStocks: Eyeing the IPO Boom<div class="everything">
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<h3><i>What does the sharp increase in initial public offerings signal about the stock market's valuation?</i></h3>
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<p>The powerful increase in initial public offerings (IPOs) signals investors in two ways. The most conventional reading is that equity markets are beginning to approach full value. After all, firms come to market when they can get better prices. But at the same time, the nature, size, and particular causes of recent IPOs raise questions about any such general interpretation. For the time being, then, the picture conforms to the judgment made by Lord Abbett in this space and elsewhere that the market, though not as drop-dead gorgeous as it once was, is, nonetheless, still attractive.</p>
<p><b>Powerful Momentum<br>
</b>IPOs have always closely followed market pricing, falling in market retreats and rising as valuations get richer. During the market crash of 2008, for example, private firms saw little return to a public offering.&nbsp; Only 27 companies went public in the United States that year, 95% less than in 2000, when more than 500 companies went public. The number has picked up with market gains. In 2010, after the economy began its admittedly substandard recovery, 136 companies went public. In the first half of this year alone, though, the figure has jumped to 165. If this pace holds for the rest of the year, 2014 will record 330 IPOs, a 100% increase over last year.<sup>1</sup></p>
<p>If this jump clearly shows confidence among investment bankers and business managers that the market is more fully priced than previously, it would go too far to attach a word like “exuberance” to their attitudes. After all, today’s volumes, though smartly up from last year and certainly from 2008, remain well below levels of the late 1990s and 2000, when words such as exuberance and overvaluation did indeed apply to equity investors and prices. Even if the first half pace continues and 2014 does see 330 IPOs, volumes would remain only two-thirds of the 500 IPOs recorded in 2000 and less than half the 724 IPOs averaged in the United States in 1996 and 1997. The enthusiasm, though becoming more evident, is nowhere near where it was when the market was clearly approaching an overvalued state.<sup>2</sup></p>
<p><b>Nature and Causes Diminish the Implicit Warning, Too &nbsp;<br>
</b>The clustering of recent IPOs also warns against generalized interpretations. More than half the offerings recorded this year so far have been in technology and biotech. These are areas noted by investors—and no less a personage than Federal Reserve chairperson Janet Yellen—wherein pricing clearly has exceeded fundamentals. It stands to reason, then, that biotech and tech companies would rush to cash in, or rather out, when they could get outsized prices. This skewing, however, suggests that such urgent pricing considerations are not so prevalent elsewhere.</p>
<p>The capitalization mix of IPOs also suggests that something other than generalized pricing gains are driving the aggregate activity. Of the 165 IPOs recorded during the first half of the year, most leaned toward larger deals. Less than 7% were valued below $50 million, and only 22% were valued below $1.0 billion. This is a very different picture from periods of generalized IPO enthusiasm over high stock prices.&nbsp; Between 1991 and 1997, for instance, some 80% of the 3,000 IPOs recorded during that time were valued at less than $50 million.<sup>3</sup>&nbsp; Commenting on this situation in testimony before Congress some months ago, David Weild, former vice chairperson of NASDAQ, noted how the United States led the world in small-capitalization IPOs in the 1990s but, despite still having the worlds’ largest gross domestic product (GDP), the United States ranked twelfth for such offerings more recently.<sup>4</sup></p>
<p>This relative lack of smaller-capitalization IPOs is stranger still when considering the likely effect of the 2012 JOBS Act. Noting that smaller firms are the economy’s key source of new employment, Congress passed this piece of legislation, formally titled the Jumpstart Our Business Startups Act, to channel more capital to smaller firms.&nbsp;</p>
<p>The bill offers five basic concessions to those the act refers to as emerging growth companies (EGCs), that is, firms with less than $1.0 billion in annual revenues: 1) the act smooths the IPO “on ramp” (to use Washington’s fun language) by gradually phasing in required compliance measures over time; 2) it allows confidential submissions of IPO registration statements with the Securities Exchange Commission (SEC), presumably to give managements more flexibility in timing their offering; 3) it exempts such firms from many of the usual disclosure statements or scales in such requirements; 4) it lifts restrictions on so-called “test the waters” communications among firms and qualified institutional buyers (QIBs) and institutional accredited investors; and 5) it relaxes restrictions on research at the time of the IPO, effectively reversing many rules adopted after the dot-com bubble burst in the early 2000s.<sup>5</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p><b>Meanings?<br>
</b>With such support, it is little wonder that IPO volume picked up in 2013 and 2014. The wonder is that it did not pick up more dramatically and that such a relatively small percentage of those coming to market were EGCs. The general impression, then, is that this IPO surge differs from the sort that would otherwise signal an overvalued market—a more fully valued market than previously, to be sure, and one with pockets of overpricing, but not a sign yet of general overvaluation. Stocks, then, would seem to offer more upside. Investors should nonetheless watch IPOs for signs when there is a truly full valuation.&nbsp;</p>
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Mon, 25 Aug 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/currencies-can-the-dollar-stifle-the-yuan.htmlCurrencies: Can the Dollar Stifle the Yuan?<div class="everything">
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<h3><i>The greenback is in danger of losing its global reserve status to China's currency, according to some observers. That, however, is not likely to happen soon.</i><i></i></h3>
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<p>Recent news about how U.S. companies have increased their use of Chinese yuan has engendered renewed fears of China. In particular, the announcement has raised concerns that the yuan might soon displace the U.S. dollar as the world’s premier currency for international trade and banking, what economists refer to as the global reserve currency. This is not the first time such anxieties have emerged. But as in previous instances, today’s fears are far from grounded in reality. Whatever Beijing implies in its public statements, it neither wants its yuan to replace the dollar nor could it, even if China’s leadership wanted it to.<b><i></i></b></p>
<p>Beijing’s rhetoric would seem to claim special status for the yuan already. Government spokesmen have promoted trading arrangements that bypass the dollar. They have frequently criticized Washington’s budget deficits as inappropriate for the government that issues the world’s reserve currency. China’s leaders on more than one occasion have advocated diversification away from the dollar at international gatherings, such as the G-20, the group of the world’s 20 largest trading nations. But if such complaints and positions are sincere on an aspirational level, the elevation of the yuan now is not at all practical.</p>
<p>For one, it would threaten China’s prosperity. For years, China has promoted exports as a means to growth by keeping the yuan cheap to the dollar and the euro and so giving its products attractive prices in global markets. Because international status for the yuan, much less reserve currency status, would prompt nations and businesses to hold it in amounts far beyond the needs for trade, such a role for the yuan would tend to push up its value and thwart this strategy. China cannot have it both ways. It will continue to opt for exports and growth.&nbsp;</p>
<p>Beijing would, of course, like to reorient its economy away from exports. As far back as 2005, a government paper acknowledged the limits of export-led growth and advocated that China rely more on domestic sources, particularly consumer spending. But this sort of transformation is far from easy and can only go slowly. Even now, the scholarly research estimates that some 30% of the country’s jobs depend directly or indirectly on exports, which account for an even greater percentage of its jobs growth.<sup>1</sup> For the foreseeable future, then, China likely will remain export dependent and unable to tolerate the rise in the yuan associated with reserve status.</p>
<p>If China’s ongoing export strategy alone stands in the way of the yuan’s internationalization, one other thing will make Beijing balk. For a currency to achieve such status, its home country must offer broad, liquid financial markets in which the whole world can trade freely, both the currency and an array of financial instruments where domestic and foreign holders can place their yuan. Presently, China offers none of this. Instead, China’s financial markets are thin, rudimentary, and far from open to the world. In part, Beijing has resisted making the adjustment because open, fluid markets interfere with government control of the foreign exchange value of the yuan. They also interfere with Beijing’s still strong desire to control the flow of financial capital in China, something it can do much more effectively now through the government's complete dominance of state-owned banks.&nbsp;</p>
<p>There is every reason to expect that at some distant future date the yuan will challenge the dollar. But that time will wait until China has reoriented its economy and no longer needs exports as a primary engine of growth. It also will wait until Beijing feels confident enough to relinquish the control it currently seeks in closed, narrow financial markets. When that time arrives, the yuan and the dollar may share the reserve role for an extended time, as the dollar and Britain’s pound sterling did for decades in the middle of the twentieth century. But all this is a long way off. In the interim, concern about the yuan supplanting the dollar is a distraction from real life. To be sure, much about the U.S. economy raises questions about the dollar’s qualifications as the world’s reserve currency. But right now, not much else has the credentials to replace it, the yuan in particular.&nbsp;</p>
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Mon, 18 Aug 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-a-token-of-our-depreciation.htmlU.S. Economy: A Token of Our Depreciation<div class="everything">
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<h3><i>In previous recoveries, capital spending exceeded depreciation by 30–50%. The current level of around 20% suggests more sluggishness ahead.</i><i></i></h3>
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<p>Much discussion in this space has delved into the substandard nature of this recovery, the reasons for it, and why the pattern will likely continue. The analysis has identified a number of causes, in particular: 1) the legacy of fear left by the Great Recession and financial collapse of 2008–09, and 2) the lingering uncertainties imposed by complex legislation coming out of Washington, primarily the Affordable Care Act and the Dodd-Frank financial reform. (See <i>Economic Insights</i> of July 7, 2014, for an <a href="/content/lordabbett/en/perspectives/economicinsights/can-the-us-economy-regain-its-old-glory.html">overview</a>, June 23 for a focus on <a href="/content/lordabbett/en/perspectives/economicinsights/us-housing-a-slow-building-recovery.html">housing</a>, May 12 for a focus on the <a href="/content/lordabbett/en/perspectives/economicinsights/consumers-why-the-united-states-isnt-the-land-of-the-spree.html">consumer</a>, May 5 for a focus on <a href="/content/lordabbett/en/perspectives/economicinsights/capital-spending-why-caution-still-rules.html">capital spending</a>, and April 28 for a focus on <a href="/content/lordabbett/en/perspectives/economicinsights/a-slow-motion-us-jobs-recovery.html">jobs</a>.) This week’s discussion returns to capital spending, easily the most affected by these concerns, and documents in a different way how these forces have subdued the pace of recovery.<b><i></i></b></p>
<p>The capital spending figures reported by the government and commented on endlessly in financial newsletters and the media all focus on current spending flows. Anyone operating a business, however, knows that the real pace of expansion also must consider rates of depreciation—from daily wear and tear, from obsolescence due to technological advances, and because price charges sometimes destroy the profitability of equipment and procedures, as when fuel cost increases render inefficient vehicles useless for business. When current spending flows fail to cover such depreciation, the economy’s productive capacity can actually shrink, however impressive the new spending figures might otherwise look. When they rise above this depreciation by a reasonable margin, the economy’s overall productive capacity expands.&nbsp;</p>
<p>Comprehensive depreciation data only go back to 1983, but still that is enough time to tease out the usual cyclical pattern. In expansions, current capital spending flows typically tend to exceed depreciation by 30% to 50%.<sup>1</sup> In recessions, that margin typically shrinks. Thus during the mid-1980s, as the economy emerged from the severe recession at the beginning of that decade, gross spending on new capital equipment, premises, and intellectual capital exceeded depreciation by an average of some 44.5%, promoting a healthy expansion in the economy’s overall productive capacity as well as an upgrade that added to the productivity of workers, who, consequently, had that much more space in which to work, more and better equipment, greater amounts of computing power, and more innovative techniques at their disposal. The recession in the early 1990s dramatically slowed this rate of improvement. Current spending flows in 1991 and 1992 still exceeded depreciation, but only by about 22%. After the economy picked up in 1993, however, the excess in capital spending over depreciation widened again, to 44.3%, for the rest of the decade, just about the amount averaged in the 1980s.&nbsp;&nbsp;</p>
<p>The pattern changed slightly in the early part of this century. Though the 2001 recession was mild by any standard, business came out of it more cautious than in the prior two decades. No doubt, the cloud of terrorism that arose at the time colored managers’ thinking. In 2003, current capital spending flows barely exceeded depreciation by 3.0%. As that recovery proceeded, however, business shed much of its fear and, subsequently, spending margins over depreciation again rose significantly. They were, however, not quite as robust as they were during the 1980s and 1990s. Between 2004 and 2007, for example, current spending flows exceeded depreciation by just about 30%—still a handsome enhancement to the nation’s productive facilities, equipment, and computing power.</p>
<p>But the Great Recession of 2008–09 and other weights or economic aggressiveness have changed things radically. In 2009, business was so traumatized that it failed to spend enough even to replace depreciated facilities. In that year’s third quarter, when the recovery was said to have begun, American firms spent 13% less for capital goods and technology than they depreciated. For the year as a whole, actual spending fell 8% short of depreciation. In 2010, such spending barely kept up. Even as the recovery became more secure in 2011, or seemingly did, business’ timidity was still apparent. That year, it spent on new capital barely 13% more than it depreciated, and in 2012 and 2013, it spent barely 20% more. What data exist for 2014 is little different. This is a very different and much less robust picture than in the economy’s past. &nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>These outlines are of a piece with the other cyclical comparisons done in this space. It tells of a traumatized economy, from the legacy of the Great Recession, as well as the associated financial failures, and from the confusion emanating out of Washington. It also reinforces the conclusion that these retarding forces will change only slowly at best. Though the economy seems set to continue its expansion, matters look slated to proceed at no faster a pace than the substandard one of recent years.&nbsp;</p>
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Mon, 11 Aug 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/fed-hawk-eyes-inflation-prospects-and-rates.htmlA Fed Hawk Eyes Inflation Prospects and Rates<div class="everything">
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<h3><i>The Federal Reserve is right on schedule by taking its time—not too fast, not too slow.</i></h3>
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<p>Philadelphia Federal Reserve Bank president Charles Plosser has, it seems, become the leading hawk on the Federal Reserve Open Market Committee (FOMC). Since the FOMC sets the nation’s monetary policy, people pay close attention. And he has frightened many of late, saying, according to some popular interpretations, that the Federal Reserve will have to get going with unwinding its extremely easy monetary policy and raise interest rates sooner and perhaps more dramatically than is generally expected. But these fears are largely misplaced. Plosser is neither as radical as he seems in some media reports nor is the inflation situation such that it will likely move him or the rest of the FOMC to shift policy dramatically.</p>
<p><b>Plosser Ain’t That Far Out<br>
</b>Plosser has been described as the “north pole of hawks on inflation.”<sup> </sup>At that, it is easy to see why traders fear his influence. But if his rhetoric has a hawkish tone, what he says is not all that different from Chairperson Janet Yellen or the rest of the FOMC for that matter. Nor has he ever advocated a sudden change in policy.</p>
<p>To be sure, throughout the entire period of extreme monetary ease, he has consistently sounded a cautionary note on inflation potentials. He was issuing such warnings as far back in 2011. But alerting his fellow policymakers and the investment community to longer-term risks is entirely different from advocating an immediate, radical policy change. Indeed, at no point did he say that the Fed should tighten immediately. He objected to the second and third phases of quantitative easing because he worried over the long-term consequences of enlarging the Fed’s balance sheet and the difficulties that would impose when it came time for the Fed to change course. But his was a dispute over technique, not the immediate direction of policy.</p>
<p>Even his most recent statements suggest nothing about a sudden shift at the Fed. In, for instance, his June 24th talk to the Economic Club of New York, he mentioned the risk of inflation, but he couched it as a risk not a likelihood. He spoke less of the immediate future than in terms of “three to four years.”<sup>1</sup> That hardly contradicts Yellen’s indication of no rate increase until 2015. Also like Yellen and many others at the Fed, Plosser insists that any change in monetary policy will hinge on unfolding economic events. As he has made clear, he would wait to raise rates above today’s near-zero levels until unemployment drops considerably more <i>and</i> fundamental inflation trends run at or above 2% a year. This is little different than the general Fed line. He has said that the Fed will probably move on rates “sooner than people think,”<sup>2</sup> but that is more a response to his reading of market expectations than a statement that things will change tomorrow. Plosser senses that traders expect rates to stay low indefinitely. He wants them to know this expectation is misplaced. In this regard, too, he is little different from Yellen or former Fed chairman Ben Bernanke before her, both of whom have issued the same message through in slightly less strident language. As with them, it also is worth noting that Plosser’s warning says nothing about a rate increase tomorrow or even before 2015 for that matter.<sup>3</sup></p>
<p><b>Inflation Aggregates Hardly Flash Danger Signals<br>
</b>Recent readings of the Consumer Price Index (CPI) might raise inflation concerns. So far this year, the overall measure, which includes food and fuel, has risen at a 2.7% annual rate. If there were reason to expect such a pace to last, it would indeed be worrisome and would also challenge the Fed to alter policy soon. But that is hardly the case. The spring acceleration in overall inflation had its roots in clearly temporary surges on fuel and food prices. None of these are likely to continue at their recent pace. Both sorts of prices have, in fact, already begun to moderate. Still, more compelling is the moderate underlying trend. The Labor Department reports that the overall CPI rose 2.0% over the past 12 months, right at the Fed’s preferred level and slightly lower than the previous 12 months.<sup>4</sup>&nbsp; &nbsp; &nbsp;</p>
<p>The Fed’s preferred inflation measure, the personal consumption deflator, offers an even less worrisome picture than that painted by the CPI. According to the Commerce Department, which collects and records the data, this index has increased so far this year at a slightly slower rate than the CPI, advancing at a 1.9% annual rate, pushed up, like the CPI, by temporary surges in food and fuel prices. A measure that excludes the effects of food and fuel pricing showed a more modest rate of increase during the two months. Longer-term trends leave even less sign of the kind of inflationary pressure Plosser and other Fed policy hawks fear. Over the past 12 months, the overall consumer price deflator increased only 1.7%, well under the Fed’s 2.0% preferred rate, and a measure that excludes the effect of food and fuel increased only 1.4%.<sup>5 </sup>Neither is a cause for concern.</p>
<p><b>Nor Do Commodity Prices Give Much Cause for Concern<br>
</b>Commodity prices, often identified as an early warning of a generalized inflation, give a mixed picture. They always do. On balance, they, too, hardly point to an imminent takeoff in inflation.</p>
<p>Most concerning when it comes to inflation are oil prices. According to the New York Mercantile Exchange, the price of a barrel rose from about $92 at the start of the year to a high of $107 earlier in July, a 16% increase.<sup>6</sup> The jump reflected the basics of supply and demand less than the fears engendered by geopolitical tensions in Ukraine and in Iraq (See <i>Economic Insights, </i>July 21.) If these matters get out of hand, oil prices could rise higher, but if supplies from Russia and the Persian Gulf continue to flow, as they have, then prices could easily fall back to where they started this year or even lower. Indeed, largely because these situations seemed to have stabilized or, at the very least, not deteriorated any further, oil prices during the past few weeks have dropped back down below $102 a barrel, a 13% drop from their highs. An inflationary momentum from this source depends on a serious deterioration in the geopolitical situation, which, though possible, is hardly a basis on which to change monetary policy, certainly not preemptively.</p>
<p>The other source of inflationary concern is meat prices. So far this year, they have risen at an astronomical rate.&nbsp; According to the Chicago Merchantile Exchange, feeder cattle, for instance, jumped almost 28% from year-end 2013 to highs earlier this spring. Lean hog prices rose more than 30% during this time. But promising future relief, wheat prices (after rising some 23% from the start of the year to April) have fallen steeply since then, so that prices year to date are actually down more than 7%. Corn prices have followed a still more dramatic pattern, shooting up and then turning down, falling year to date on balance by just less than 17%. And, indeed, meat prices already have begun to moderate. Feeder cattle and lean hog prices have each dropped about 3% during the last couple of weeks.<sup>7</sup></p>
<p>Meanwhile, other commodity prices look reasonably moderate. Gold prices, often seen as a proxy for general expectations on inflation, have risen so far this year, gaining about 12%. But they remain more than 25% below their highs of late 2012. And gold is already off 2.0% since hitting recent highs earlier this spring. Industrial price indicators also offer a moderate picture. Copper prices, for instance, after falling with the weather-induced economic slowdown earlier in the year, have risen again more recently. They nonetheless remain below the levels at which they began the year. Lumber prices have followed a similar down and up pattern, but at present they remain more than 8.0% below the levels at which they began the year. The Dow Jones-UBS Overall Commodity Index, though up about 5.0% so far this year, has already dropped from its recent highs.<sup>8</sup></p>
<p><b>Nor Do Wage Patterns Raise Any Inflationary Flags<br>
</b>Wages, as Plosser is often at pains to explain, tend to lag. Still, they remain a crucial indicator of whether the Fed needs to worry about what economists call a wage-price spiral. This pattern, usually identified as the main source of any sustained inflationary momentum, is when wages rise to keep pace with expected inflation, forcing managements to pass through the costs in higher prices, causing those expectations to be realized, and, in the process, sustaining a general price advance. Here, too, there is little to no sign a dangerous inflationary pressure that might warrant an abrupt shift in monetary policy, including premature rate increases.</p>
<p>So for this year, the Labor Department reports, hourly earnings of all employees have risen 1.2%, or 2.5% at an annual rate. Weekly earnings have increased 1.7%, or 3.4% at an annual rate. In itself, these figures would hardly send up an inflationary flag. After all, productivity has grown about 1.0% during the past year and has trended up at an even faster rate, suggesting little cost pressure in these wage gains, certainly none in excess of the Fed’s inflation preference. What is more, these earnings gains would have come in even lower were it not for the relatively heavy use of overtime. There is no sign here of even the beginnings of a wage-price spiral that might force the Fed’s hand on policy. Nor is this year very different from the recent past. Over the last two years, hourly earnings have risen at a 2.1% annual rate and weekly earnings have increased at a 2.2% annual rate. After accounting for productivity advances, costs are rising at a pace well below the 2.0% informally targeted by the Fed.<sup>9</sup></p>
<p>Different industries exhibit considerable variation in wage gains. That, of course, is always the case. But there is no sign of a widespread acceleration that might create concern about a wage price spiral. Just using broad measures can give an indication. Weekly earnings in goods producing industries have risen at a 2.6% annual rate during the past two years and at a 3.3% annual rate so far this year, a slight acceleration but hardly enough to warrant a policy shift, especially because manufacturing productivity increased 2.3% during the past year, taking most of the cost sting out of such earnings increases. In services, weekly earnings have risen at a 2.0% annual rate in the past two years and at a 3.5% annual rate so far this year. This acceleration, too, implies only modest cost pressures and no hint of a wage-price spiral. A further acceleration could raise legitimate concerns in this regard, but that is nowhere in the data, certainly not yet.<sup>10</sup></p>
<p><b>Pulling the Pieces Together &nbsp; &nbsp;&nbsp;<br>
</b>To be sure, past extreme monetary ease engenders concern of ultimate inflationary pressure. It is why Plosser attracts so much attention in the financial community. Many there share his fears. But for all the reasonableness of such thinking, clearly little or nothing in today’s statistics point to an immediate realization of such concerns, certainly not enough to justify a sudden change in monetary policy. But if there is no pressing need for the Fed to deviate from plan, Plosser’s policy warnings are right in principle. Ultimately, the Fed will need to move away from its policies of extreme ease. It will have to do so before the inflationary momentum builds. The decision to taper quantitative easing and to end the program this fall is a part of this plan. So, too, is the Fed’s decision to begin to raise interest rates gradually next year and then go on overtime to normalize the Fed’s posture and its balance sheet. But all of this, whether described by Plosser, Yellen, or even the monetary doves on the FOMC, should unfold very gradually and, as the economic situation seems to demand, no sooner than scheduled.&nbsp;</p>
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Mon, 4 Aug 2014 09:40:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/jobs-recovery-half-speed-ahead.htmlJobs Recovery: Half-Speed Ahead<div class="everything">
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<h3><i>While nonfarm payrolls growth is improving, the pace still lags previous rebounds.</i></h3>
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<p>The jobs figures for June looked fairly good. The unemployment rate fell to 6.1% of the workforce, and non-farm payrolls expanded by 288,000 and across a broad front of industries and occupations. So far this year, the economy has created 1,385,000 new jobs.<sup>1</sup>&nbsp;President Obama was at particular pains to point out that payrolls have at last topped their former high from before the Great Recession. This is all welcome news, but it looks good only when set against subpar patterns made familiar in this otherwise substandard recovery. Perhaps the acceleration of the last few months signals a positive change. Yet it is hardly impressive by the standards of other recoveries, and nothing in the data suggests much better anytime soon. &nbsp;&nbsp;</p>
<p><b>Overall Employment Picture<br>
</b>Even on the surface, overall payroll growth tells this disappointing story. It has, after all, taken almost six and a half years for payrolls to recapture their former high. Table 1 reveals how painfully protracted this has been. The second column shows the time in each cycle required for payrolls to top their former employment highs. Of the 10 previous cyclical expansions since the end of the Second World War, the average comes to one year and 10 months. The worst performance other than the present recovery was earlier in this century, when it took the economy three years and 10 months to get back to the old highs, a wait that prompted the media to term that period as a “jobless recovery.” &nbsp; &nbsp;&nbsp;</p>
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<p><b><span class="rte_txt_green">Table 1. Total Payroll Gains in Past Cycles</span></b></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/JobsRecoveryTables%23114D82.png"></p>
<p><span class="legal">Source: National Bureau of Economic Research and the Department of Labor.<br>
*Annualized percent growth rate in payroll employment for the five years following the initial downturn or to the next cyclical peak, if it came within that five-year stretch.<br>
<sup>+</sup>Because these cycles came one right after the other, the calculation on employment’s growth pace was made as if they were a single cycle, starting the calculation at the beginning of the first cycle.</span></p>
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<p>If this is an unpleasant picture, there is one piece of good news embedded in these current figures. During the last year and a half, payroll employment growth has proceeded at an annualized pace of 1.7%. That figure is about the average recorded during all the other cycles. It is encouraging to believe things are back on trend, even if such a pattern would promise no catch-up for the relative ground lost during the majority of this expansion. The last column in the table puts into even sharper relief the inadequacies of this recovery so far. It shows the annualized pace of employment growth in the first five years after the initial downturn (or until the next peak, if the entire recovery was shorter than five years). There is quite a bit of variation from one cycle to another. The average rate of jobs growth, for what it is worth in such a varied sample, equals about 1.6% a year. The worst performance before this recovery occurred in the first few years of this century, when jobs growth averaged only 0.5% a year for the five years of the calculation. But by today’s standards, that looks fairly good. This recovery is the only one that saw a drop in net employment growth over such a long stretch of time. Of course, the five-year measure only goes to January 2013. Since then, the economy has created more jobs, so that finally this June payrolls exceeded that past peak.</p>
<p><b>Participation and Part Time<br>
</b>The media and many market commentators have used other measures to characterize this recovery. In particular, they have made much about the extent of long-term unemployment as a sign of economic ill health. They have drawn a similar conclusion from the drop in the general participation in the workforce. This consensus would seem to be on the mark with its selection of unemployment duration, but when it comes to workforce participation, the population’s aging trend muddies the analysis and so, also, such simple conclusions.</p>
<p>Long-term unemployment in this recovery is quite simply unprecedented. And the appropriate word is <i>recovery</i> not recession, because the troubling trend actually developed after the economy turned upward. Until this cycle, the highest the long-term unemployment (27 or more weeks) rate ever became as a percentage of total unemployment was 26.0%. That figure was recorded in June 1983, just after the economy’s late-1982 trough.&nbsp; Typically, the economy suffers this debilitating unemployment most in the early months of recovery, before the pickup in economic activity can have its effect on labor markets. But in this cycle, the figure reached new highs even before the downturn ended, when long-term unemployment rose to 23.1% of total unemployment in late 2008. The percentage touched 34.0% at the economic trough in June 2009, the month that the economy began its upturn, and then it continued to rise for <i>two years more</i>, far longer than in any past recovery. Ultimately, in September 2011, it reached levels of 45.0%, almost double the former high. It has edged down since, but even in the most recent report for June, long-term unemployment still averaged 32.9%, far higher than the worst ever reached previously. The decision to increase the duration of unemployment benefits clearly factored in here, but this pattern also testifies to the remarkable weakness of this recovery generally. &nbsp;</p>
<p>The participation of people in the workforce has fallen off during this recovery, too. Labor Department figures put participation in the workforce of all those over 16 years of age at almost 66.4% in 2007 just before the Great Recession began. By the cyclical trough of June 2009, the figure had dropped to 65.7%, and has since fallen to 62.8%. Many point to this trend and describe armies of discouraged people who have given up the job search. There is no denying the large numbers of discouraged workers, but there is more at work here than just discouragement. Because the participation statistics count all those above the age of 16, the data are susceptible to distortion by the growing numbers of retirees in the population. This is no small effect. Since 2005, the proportion of the population over 65 years of age has increased by about a full percentage point, to more than 13%. That proportion is expected to continue to rise, according to the Census Bureau, toward 20% of the population in the next seven to 10 years. Though these trends have many economic implications, the participation figures reflect more than just the relative strength or weakness of the recovery. &nbsp;&nbsp;</p>
<p><b>Part Time and Prospects<br>
</b>The last major &quot;tell&quot; on this recovery’s substandard nature emerges from the relative growth of part-time employment. Here, the figures cannot be described as unprecedented, but they are nonetheless striking. Table 2 tells the story. It tracks temporary employment as a percentage of total employment in past economic cycles as well as in this one. There clearly is a lot of variation, but still a clear pattern. Part-time work rises as a percentage of all work in economic hard times and falls as the recovery gains momentum. This measure became particularly high in this recent recession, hitting 6.9% of all employment. But that was not a record. The all-time high of 7.6% was set during the 1982 recession. Matters have improved in this recovery, as they did in every other recovery, but they remain high. In the most recent accounting for June, the percentage of jobs that are part time stood at 5.4%, just equal to the record set during the recovery in the mid-1980s. &nbsp;</p>
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<p><b><span class="rte_txt_green">Table 2. Part-Time Workers as a Percent of All Workers</span></b></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/JobsRecoveryTables%23114D83.png"></p>
<p><span class="legal">Source: National Bureau of Economic Research and the Department of Labor.<br>
*Or at the next cyclical peak if it occurred sooner.<br>
<sup>+</sup>Because the 1980 recession bled into the recession of 1981–82 recovery, this accounting ignores the 1980 trough and makes its calculations based on the 1982 trough.</span></p>
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<p>Prospects now, after so much disappointment, seem to offer little better than this substandard past. The influences that have kept this recovery slow remain largely in place. The detailed review in the July 7th <i>Economic Insights</i>, “<a href="/content/lordabbett/en/perspectives/economicinsights/can-the-us-economy-regain-its-old-glory.html" target="_blank">Can the U.S. Economy Regain Its Old Glory?</a>” revealed two basic considerations. One is the lasting effects of the Great Recession, which generally has dampened appetites for risk among business managers, bringing great caution in its train, especially regarding full-time staffing decisions. The other is the continued weight of the complex legislation that came out of Washington in 2010, most notably the Affordable Care Act and the Dodd-Frank financial reform law. Aside from whether these are good policies or bad, they introduced great uncertainty into business planning by obscuring future staffing and credit costs—a state that could not help but also subdue business’s willingness to hire, expand, or take risk generally. Since so much remains to be clarified about the legislation, it would seem that its ill effects on hiring will likely linger for some time yet to come. Time will heal the scarring from the Great Recession, but that, too, seems likely to occur only very gradually.&nbsp; Perhaps the return of payroll growth to trend betokens relief on this front, but it is too soon to declare an end to the disappointing patterns exhibited so far in this recovery.</p>
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Mon, 28 Jul 2014 08:55:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-euro-why-the-low-spirits.htmlThe Euro: Why the Low Spirits?<div class="everything">
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<h3><i>Here’s a look at the factors behind the common currency’s slump versus the U.S. dollar—and its prospects in the months to come. &nbsp;</i></h3>
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<p>The euro has lost considerably to the dollar since spring. Most recently, the drop reflects the deep trouble at Portugal’s biggest bank, the Espirito Santo Group. But apart from this reminder of how tenuous the Continent’s financial balance is, the euro’s decline against the dollar has two, probably fundamental causes. One is the drop in rates and yields in Europe, by both market action and European Central Bank (ECB) policy. The other is the geopolitical risk generated by circumstances in Ukraine and Iraq, both of which have, at the margin, produced a preference for American assets rather than European assets. Since all these differences are likely to persist, the euro should continue to lose ground to the dollar for some time, though at a more subdued pace than recently.&nbsp;</p>
<p><b>The Influence of Rates<br>
</b>No doubt ECB rate policy has factored into the currency equation.<sup>1</sup>&nbsp; In just the last few weeks, the ECB has: 1) cut its main policy rate (the equivalent of the fed funds rate in the United States), from 0.25% to 0.15%; 2) cut the rate it charges on direct lending to banks (the equivalent of the discount rate in the United States), from 0.75% to 0.40%; and 3) for the first time ever brought its deposit rate—what it pays banks on reserves they leave at the ECB—into negative territory, a charge of 0.10% a year. Since this country’s dollar-based rates have stayed more or less steady through this time, these ECB moves have marginally increased the attractions of dollar-dominated paper, affecting flows and altering currency values accordingly. To be sure, the euro began to slide against the dollar before the ECB altered policy, but these moves were telegraphed by policymakers, including ECB president Mario Draghi, weeks before they were actually put in place, no doubt affecting decisions on the placement of even very short-term money flows.</p>
<p>Movements at the longer end of the yield curve have had their independent effect. German government 10-year yields, for example, have dropped by almost 40 basis points (bps) during the past year, to about 1.3%, while yields on comparable bonds in the United States have risen slightly, to more than 2.6%. Yield spreads accordingly have widened by 50 bps in the dollar’s favor, to 130 bps. Perhaps even more significantly, investors, convinced it seems that Germany and the ECB would back bonds issued by Europe’s troubled periphery, have moved into Greek, Spanish, Italian, and Portuguese bonds, bringing down their yields, respectively, by 562 bps, 209 bps, 166 bps, and 388 bps. Some of these otherwise risky bonds now offer barely any premium over U.S. Treasury issues. Even the yield premium on Greek bonds, where fears of default and rescheduling were actively considered not too long ago, is comparable to junk corporates in the United States. It is then little wonder that investors have turned increasingly toward U.S. markets with a commensurately positive effect on the dollar relative to the euro.<sup>2</sup></p>
<p><b>Geopolitics, Oil, and Bet Hedging &nbsp; &nbsp; &nbsp;<br>
</b>The dangers implicit in Ukraine and Iraq have also factored into the pro-dollar equation. It is no coincidence that the latest slide in the euro began with Russian intervention, first in the Crimea and then in Ukraine’s eastern and southern provinces. On the simplest level, the dollar’s appeal rests on geography. The euro has suffered because the currency zone is closer to both Ukraine and Iraq than is the United States. But the matter is more complex than just geography. Both geopolitical touch points have much to do with oil, and there the dollar has the fracking revolution on its side.<sup>3</sup>&nbsp; &nbsp;</p>
<p>The most immediate pressure, and no small consideration in currency moves, is Europe’s clear and direct dependence on Russian energy supplies, most of which pass through Ukraine. Estimates vary in aggregate, and certainly country by country, but a fair bet is that Europe as a whole depends on Russia for more than 30% of its oil and gas. That makes European economies and markets highly valuable to an interruption, whether because the Russians use oil as a weapon or because an enlarged civil war in Ukraine stops shipments. To be sure, oil is a global commodity. Troubles in Ukraine would force the Russians to find other buyers. The energy supplies immediately denied Europe would flow elsewhere into world markets. Ultimately, Europe could tap other sources freed up by this diverted Russian flow or tap the Russian flow indirectly. Such an ultimate remedy, however, would take a long while, quarters, maybe years. In that long hiatus, Europe’s economies and markets would suffer disproportionately, making the dollar preferable to the euro, certainly at the margin.<sup>4</sup>&nbsp;&nbsp;</p>
<p>Iraq is a bigger threat. Though to date oil continues to flow despite all the fighting, the chaotic and highly uncertain situation in that country, and in the region generally, threatens to cut off substantial energy flows from a part of the world. In this case, the threat is not, as in the case of Ukraine, of an interruption in flows or a redirection. Rather, it is one of lost supplies, some 30% of world flows, according to the Energy Information Administration. Of course, that danger exists for the world’s economy, not just Europe’s. But in assessing relative vulnerabilities, investors and market participants in general cannot help but take account of the new supplies made available by the fracking revolution in the United States and the new technologies freeing oil from Canada’s tar sands. In the past five years, these have increased North American production from just over 10% of global supplies to more than 15%. Meanwhile, European production, mostly from the North Sea, has dropped from almost 5% of global output to less than 3%.<sup>5</sup></p>
<p>While such risk considerations no doubt color investor preferences and, hence, relative currency movements, the fracking revolution also has had an impact on currency suppliers. Because of the growth of domestic energy sources, the United States imports considerably less oil than it once did, and so supplies commensurately fewer dollars to global markets. According to the Commerce Department, the U.S. international balance on petroleum products has improved by some 8.5% just since this time last year, or by some $20 billion—a supply of dollars that otherwise would have entered global currency markets. Of course, oil flows are not the only factor even in this immediate supply-demand equation. This country’s overall international balance has deteriorated by some 5%, or $12 billion, indicating that other aspects of this country’s international account more than offset the energy improvement. Still, pricing accounts for trends as well as outstanding supplies at each moment, leaving room for markets to price in an impact from this tendency from fracking to stem the net supply of dollars into world markets.&nbsp;</p>
<p><b>Prospects<br>
</b>Neither of these influences promises to go away any time soon. The ECB, worried about extremely low inflation and the threat of deflation, has all but promised future rate cuts and other forms of monetary support, such as quantitative easing. Against this picture, the Federal Reserve is tapering its own quantitative easing program. If it is unlikely to raise short-term rates anytime soon, all its rhetoric emphasizes a future need to do so.&nbsp; In such a milieu, short rates and long yields in the United States are hardly likely to fall. Risk-adjusted rates and yield differences seem set to continue to favor the dollar.</p>
<p>To be sure, this rate equation would change if the eurozone were to experience deflation. Then the real value of the currency would rise as a matter of course, raising its attractiveness, much as Japan’s deflation raised international interest in the yen, at least for some purposes. But Europe has not yet experienced broad-based deflation. Even if it were to experience some deflation, it would take a while before market perceptions changed. In the meantime, these rate differences would hold sway and in the dollar’s favor.</p>
<p>No doubt the euro would gain relatively were the world to enjoy a happy resolution of tensions in Ukraine or the Middle East. Though anything can happen, and such things are harder to predict than currency shifts, which are none too easy themselves, these problems seem very far from resolution. Instead, they show every sign of becoming still more complex and less tractable. Still, the initial impact has passed. Currency (and other) markets will almost certainly continue to weigh them in favor of dollar assets, as described. The marginal influence over time will, however, impel a more gradual price impact than during recent weeks and months, during which time markets have had to deal with the dawning fact of such problems.&nbsp;</p>
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<p><span class="legal"><sup>1</sup> All data in this paragraph from the European Central Bank website, <a href="http://www.ecb.eu/">www.ecb.eu</a>.<br>
<sup>2</sup> Data from the statistics pages of <i>The Wall Street Journal</i>, July 11, 2014.<br>
<sup>3</sup> Data from the Energy Information Administration.<br>
<sup>4</sup> Ibid.<br>
<sup>5</sup> Data from the Department of Commerce.</span></p>
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Mon, 21 Jul 2014 09:17:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/central-bank-policiesmedicineormalady.htmlQuarterly Roundtable: Central Bank Policies—Medicine or Malady?<div class="everything">
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<h3>Extraordinary measures helped end the financial crisis, but are there unintended consequences?</h3>
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<p><b>In Brief</b></p>
<ul>
<li>New policies announced by the European Central Bank are unlikely to boost lending and economic growth as intended. But a form of quantitative easing, which would involve the purchasing of asset-backed securities, could have some effect.</li>
<li>Quantitative easing by the U.S. Federal Reserve has not re-created a credit bubble similar to that which led to the crisis. Today, there is much less leverage in the financial system than there was in 2007. Some asset classes, however, may be in a bubble, while others are still reasonably valued.</li>
<li>Quantitative easing was an appropriate response to the financial crisis, and extending it boosted asset prices, resulting in greater consumer confidence. But extended QE also may have allowed politicians to delay necessary structural reforms that could lead to stronger economic growth.&nbsp;&nbsp;</li>
<li>Ultimately, QE is likely to result in higher inflation and higher interest rates, though the Fed may hold its securities portfolio to maturity, avoiding the problem of how to sell those securities without disrupting the market.</li>
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<p>Anemic economic growth and a growing fear of deflation prompted the European Central Bank (ECB) to launch four new policies in June 2014 that are intended to jumpstart lending to small businesses and to end the recession that began in 2011. The ECB is also considering a form of quantitative easing that would involve purchasing asset-backed securities instead of sovereign debt. These extraordinary measures highlight the large role that central banks continue to play in the recoveries of developed market economies, which began with the Federal Reserve’s emergency measures at the height of the crisis. Increasingly, investors and policymakers are beginning to assess more critically the effectiveness of these policies and to gauge their long-term impact.</p>
<p>Have historically loose monetary policies in developed markets been effective or are they potentially reflating the credit bubbles that led to the crisis in the first place? Could the Fed’s quantitative easing policy be hindering the recovery rather than helping it? What is the likely long-term effect of easy money in major developed markets, and how should investors prepare for it? Addressing these topics are <b>Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income Strategist; Harold Sharon, International Strategist; </b>and<b> David Linsen, Director of Domestic Equity Research.</b> &nbsp;&nbsp;</p>
<p><b>Q: The ECB has announced new policies designed to boost economic growth. In addition to cutting its official interest rate by 10 basis points (bps), the central bank will impose a negative interest rate on excess bank funds deposited at the ECB and will offer four-year loans to banks to encourage them to lend to small businesses. How effective are these policies likely to be? &nbsp;</b></p>
<p><b>Zane Brown:</b> These policies are more likely to result in lower interest rates than they are to produce greater lending and economic growth. Banks are already concerned about the bad debts on their balance sheets and about their leverage. And they will be soon undergoing stress tests by the ECB. So, they have little interest in any lending that would jeopardize their capital-adequacy ratios.</p>
<p>The ECB’s four-year lending program, known as Targeted Long-Term Refinancing Operations [TLTRO], will make loans available to banks at a rate of 25 basis points (bps). But the banks won’t have to demonstrate that they’ve done any lending for the first two years. So, some are likely to obtain this cheap funding and invest it instead of lending it. And in two years, they’ll just give it back. But in the meantime, the profits they earn on the investment will help them recapitalize. But this policy will do little to boost lending or economic growth.&nbsp;</p>
<p>The other new policy—negative interest rates on deposits at the ECB—also won’t do much to stimulate lending. The idea is that a negative interest rate will encourage banks to lend that money instead of keeping it on deposit with the ECB. But the banks may just move those deposits to other vehicles that don’t charge them a negative interest rate. As a result, those banks may bid up short-term investments, reducing short-term rates, which could in turn hurt the euro.</p>
<p>The possibility of currency risk could then make international investors less likely to want to hold those securities, encouraging them to look elsewhere for higher-yielding opportunities. As a result, short-duration securities in the United States and higher-yielding opportunities in emerging markets may look more attractive.</p>
<p><b>Milton Ezrati:</b>&nbsp;There’s also a question of demand. These economies are sinking or stagnant, and their governments have implemented policies of fiscal austerity. So, there isn’t a lot of demand for loans.</p>
<p><b>Q: The ECB is also considering a form of quantitative easing [QE] that would involve the purchasing of asset-backed securities instead of sovereign debt. What’s the likely impact of this program?</b></p>
<p><b>Brown:</b>&nbsp;This is actually a pretty clever idea. The difficulty with a QE program that buys sovereign debt is that the ECB must buy a proportionate amount from each eurozone member country. This means that to provide help to Greece, Spain, or Italy, for example, the ECB would have to purchase a large amount of Greek, Spanish, or Italian debt. But to do that, it would have to purchase an even larger amount of German debt. But Germany doesn’t need that help. By buying asset-backed securities instead of sovereign debt, the ECB avoids that problem.</p>
<p><b>Harold Sharon:</b>&nbsp;The main issue I see is that while the ECB can implement some of these auxiliary monetary programs, like targeted loans and private asset purchases, they can’t actually control the extent to which these are pushed down into the real economy. There’s no guarantee the lending programs will be taken up fully. If trying to rectify the transmission mechanism of monetary policy into the real economy is the stumbling block, these programs offer up partial solutions, but they can only succeed if economic participants believe there will be better growth.&nbsp;</p>
<p>So maybe the next set of actions will not be by the ECB but instead will be the EU [European Union] Commission loosening the fiscal deficit compact in which it targets a maximum deficit of 3% of GDP [gross domestic product]. Perhaps the Commission will let the target deficit slip to 4% for a transitional period.&nbsp;</p>
<p><b>Brown:</b>&nbsp;Even if demand for loans is weak, buying asset-backed securities would put more money into the economy and help the banks. If a bank, say, has €100 million in loans on its books and sells them to be securitized, it gets them off the books and improves its capital ratios. It can then take the €100 million in proceeds, keep €50 million, and lend out €50 million. That would improve its capital ratios and still put an additional €50 million into the economy.</p>
<p><b>Ezrati:</b> What Zane is describing is important because the ECB has been thwarted in its attempts to reliquefy the banks, so this is a backdoor way to do that. The ECB is not allowed to lend directly to banks or to buy bank debt; it is allowed to lend only to sovereigns. But this way, it would be reliquefying the banks, even though it’s not allowed to do that.</p>
<p>The other problem with these new policies is that they’re not appropriate for the largest economy in the eurozone, Germany. Germany is now complaining about a bubble in its economy because interest rates are too low.</p>
<p><b>Sharon:</b> One stark difference between the U.S. and European credit markets is that in Europe 80% of credit funding goes through the fragmented banking system and only 20% through credit capital markets. In the United States, the bond markets are massively larger than those in Europe. So the focus on increasing bank liquidity and clearing up capital levels is crucial.</p>
<p><b>David Linsen:</b>&nbsp;Even with the new lower interest rate, the eurozone’s monetary policy is still tighter, in real terms, than U.S. policy. The fed funds rate is essentially zero, and we have approximately a 2% rate of inflation, giving us a real short-term interest rate of about -2.0% [nominal interest rate – inflation rate = real interest rate]. But the eurozone has an official interest rate of near zero and an inflation rate of less than 1%, giving the eurozone a real interest rate somewhere between 0 and -1.0% .</p>
<p><b>Ezrati:</b>&nbsp;That’s right. Two years ago, the eurozone’s official rate was higher, 1.5%, but inflation was 2.5%. So, the eurozone’s real interest rate was -1.0% [1.5% - 2.5% = -1.0%].<sup>1&nbsp;</sup> Today, despite the lower nominal interest rate, the eurozone’s policy is tighter because its real, inflation-adjusted interest rate is higher [less negative].&nbsp;</p>
<p>This is important, because extremely low inflation means the ECB’s job has become much harder than it was last year. As inflation falls, even low interest rates look less appealing in real terms. The ECB is just trying to buy time for everybody to get their balance sheets in order. But if the eurozone is on the verge of deflation, then the window of opportunity to allow that to happen is closing quickly, and any excess debt on corporate, consumer, or government balance sheets could begin to look more and more burdensome.</p>
<p><b>Q: Is there any danger that by keeping rates low, central banks are just reflating the credit bubble that led to the credit crisis?</b></p>
<p><b>Brown:</b>&nbsp;There’s not as much leverage in the system today as there was in 2007. In addition, much of the new financing that is occurring today is <i>re</i>-financing, which is enabling many companies to lower their interest costs, and to lock those lower interest costs in for a long period of time. As a result, these companies are even better-positioned to withstand periods of slow growth in the future. So, we’re certainly not in a [credit] bubble.</p>
<p><b>Ezrati:</b>&nbsp;The same is true in the household sector. Consumers have reduced the cash flow burden of their debt and they’ve improved their balance sheets.</p>
<p><b>Brown:</b>&nbsp;Certainly, investors need to be aware of risks on particular securities, but we don’t see the same subprime risk, where lending standards had been lowered to ridiculous levels. So, the quality of the lending is better today, and even though there has been an increase in covenant-light loans, the credit quality of companies is better today than in 2007.</p>
<p><b>Ezrati:</b> The question is, then, where is the bubble? If you look at asset pricing, the bubble is in all the asset classes that historically have been high quality, and low risk. The only bubble I can see is in Treasuries, agencies, and high-grade paper. Stocks certainly are not in a bubble. Yields are low in the high-yield market, too, but the spread over Treasuries is nowhere near where it was prior to the crisis.</p>
<p><b>Brown:</b>&nbsp;High-yield spreads relative to Treasuries are narrower than they have been historically, and recently [as of June 20] that spread went below 400 bps. But in 2007, it got down to 266 bps. So, we have a long way to go before we get to that level.<sup>2</sup></p>
<p>I think it’s also important to think about the yield spread in the context of the underlying Treasury yield. So, if the spread of high-yield bonds over Treasuries is 400 bps when Treasuries are yielding 2.5%, that’s proportionately greater than if that spread is 400 bps and Treasuries are yielding 5%. I think the spread that an investor demands from high-yield bonds depends to some extent on how much the underlying Treasuries are yielding.</p>
<p>Often, when high-yield spreads narrow, they can stay at that level for years. And we have found that when Treasury yields go up, high-yield spreads compress further. So, when the yield on the 10-year Treasury goes from around 2.6% [as of June 20] to 3%, we may see no movement at all in the yield on high-yield bonds, resulting in a narrower spread.&nbsp;&nbsp;</p>
<p><b>Sharon:</b>&nbsp;You could argue that the decade of low interest rates did create some bubbles in various emerging market economies, as seen, for example, through real estate in Asia, consumer prices in Brazil, etc. There also has been relatively rapid price appreciation in some of the northern European asset markets, but perhaps not yet into bubble territory. Some economies still need low rates to repair household balance sheets and to stimulate growth. The hard part is that the low rates are everywhere and, in time, they may lead to more mispriced assets.</p>
<p><b>Q: Some economists have raised the question whether quantitative easing [QE] is part of the problem instead of the solution. Most economists would agree that it has been disruptive to emerging markets. But some also believe that by turning on the monetary stimulus every time the economy appears to struggle, central banks are stealing growth from the future and not permitting the business cycle to run its normal course. Is QE part of the problem?</b></p>
<p><b>Brown:</b>&nbsp;To the extent that QE has kept interest rates low here, it has encouraged investors to search for yield in emerging markets. Last year, when the Fed began to talk about tapering the QE program, our interest rates began to rise, and some of the funds that had flowed to emerging markets came back here. So, yes, QE has had global effects.</p>
<p><b>Linsen:</b>&nbsp;The question is, is QE better than the alternative? Every policy decision has consequences, and although there may be negative consequences to QE, the consequences of not doing QE would have been worse. That was [former Fed chairman Ben] Bernanke’s argument in support of QE.</p>
<p><b>Ezrati:</b>&nbsp;To put it another way, there was nothing else the Fed could have done, because to let the cycle run its course would have caused so much economic harm. Has QE gone on too long and should it have been extended beyond the immediate crisis period? We could debate that endlessly.</p>
<p><b>Sharon:</b>&nbsp;Right, it has been a useful response to eliminate the worst-case economic collapse, but if pursued too long, it eliminates not just the natural economic cycle but also weakens the fortitude of politicians to do their part through structural economic reforms that enhance productivity and growth. We’ve seen a real lack of political follow-through around the world, and I wonder if we missed the chance to truly restructure obsolete and uneconomic rules and regulations around the world.</p>
<p><b>Linsen:</b>&nbsp;QE, however, also led to higher asset prices, which led to higher business and consumer confidence. Higher confidence and greater investment lead to job creation. Just this month, the U.S. economy exceeded the pre-crisis peak in jobs. What would the U.S. economy have looked like without these positive impacts of QE?</p>
<p><b>Ezrati:</b> Some researchers at the Fed studied the effects of QE3 and concluded it had no effect because the stimulus didn’t reach the real economy. It got bottled up in the banks and never reached Main Street, which is what the Fed was trying to accomplish. The researchers also found that QE3 didn’t keep long-term interest rates down much. They concluded that short-term rates were low because the fed funds rate was kept low, not because the Fed was buying long-term debt.</p>
<p>It seems to me that Fed chairperson Janet Yellen may have taken these findings to heart because she seems determined to continue with tapering the QE program.</p>
<p><b>Brown:</b>&nbsp;In the next year or so, when the Fed begins to raise rates, that could attract investors from other parts of the world, including emerging markets. So, there will be consequences for emerging markets, and they may have to take steps to counter the effects of our tightening.</p>
<p><b>Linsen:</b> What you’re saying is that a healthy U.S. economy will have a tightening effect on emerging markets.</p>
<p><b>Sharon:</b>&nbsp;It does appear the decade of low interest rates, which boosted growth in emerging countries, has come to an end. At the same time, we see China, the largest driver of that growth, shifting its economic model from export-driven to one of consumption and likely we will see growth moderate to around the 7% level and not the 10% level as in years past. This clearly will have knock-on effects to all the commodity-based emerging countries.</p>
<p><b>Q:&nbsp; What is the end game? How will this unprecedented monetary accommodation work out?</b></p>
<p><b>Ezrati:</b> The end game is: watch out for inflation.</p>
<p><b>Brown:</b>&nbsp;Inflation and higher interest rates. Higher rates are likely, because as the Fed ends its securities purchasing, somebody will have to step in and replace that lending, which the Fed did at lower-than-market rates when it purchased those assets at high prices. So, as we return to market-based interest rates, those rates are likely to be higher.</p>
<p><b>Linsen:</b>&nbsp;Average hourly earnings are rising by only about 2% per year, and I don’t think rates are likely to go much higher until we see some tightness in the labor market.<sup>3</sup></p>
<p><b>Ezrati:</b>&nbsp;If you believe Bernanke and Yellen, the Fed will act before that occurs. If we’re going to avoid this inflation, the Fed will need to remove the excess stimulus before inflation occurs. That’s what makes this such a delicate environment. Bernanke laid out a multi-step program for doing this, which involved reversing every step in QE before raising short-term interest rates.&nbsp;</p>
<p><b>Brown:</b>&nbsp;I think the Fed realizes that it can’t sell these assets even in 2015, because investors would panic.</p>
<p><b>Ezrati:</b>&nbsp;Right. It would be the “taper tantrum” in spades. But the Fed doesn’t have to sell because a lot of its debt isn’t long term. So it could just let its assets mature. I don’t know what the average maturity is of the assets on the Fed’s balance sheet, but it’s pretty short.</p>
<p><b>Linsen:</b>&nbsp;The Fed also doesn’t have to sell because the new view at the Fed is that prior to the crisis, its balance sheet may have been too small in relation to the economy; but now, at more than $4 trillion, it’s about the right size.</p>
<p><b>Q: So, if the Fed is not going to remove the excess monetary stimulus from the economy and investors should count on significant inflation in the future, what would be the investment implications of this scenario?</b></p>
<p><b>Brown:</b> The bottom line is that if Fed expectations are realized and the ECB policies meet with some success in the eurozone economic growth in the United States and Europe should improve and equities should do well.</p>
<p>In this environment, a gradual return to normal monetary policy and inflation will push interest rates higher, hurting the price of high-quality fixed income, especially longer-term Treasuries and agencies. An investment strategy designed to address rising inflation expectations would be appropriate. Also, lower-quality securities in the United States and elsewhere are less interest rate-sensitive and more economically sensitive and should, therefore, perform better than their high-quality counterparts.</p>
<p><b>Sharon:</b> I see the cycle outside the United States as a bit behind the cycle in the other large economies. To wit, Japan and Europe are still expanding their quantitative easing. Given that difference, it makes sense to be exposed to economically sensitive assets, especially where valuations also still make sense. I wrote in our investment blog at the beginning of the year about the attractiveness of European equities, and I still think they are attractive. Corporate profits are improving and should be initially immune from modest inflation if it comes about. I think the inflation threat outside the United States is significantly less at this point, though. As we know, equity markets react to the unpredictable events that are positive, and I would expect that we will see surprise pro-growth policies implemented in Europe and some parts of Asia. Our most economically sensitive strategies are international small cap and our value strategy, which had the added benefit of earning high quarterly cash flows from the large dividends being paid by healthy growing foreign companies. &nbsp;&nbsp;</p>
<p><b>Q. Thank you, gentlemen.</b></p>
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<p><span class="legal"><sup>1&nbsp;</sup>Data from Bloomberg.<br>
<sup>2</sup>&nbsp;Data from Bloomberg.<br>
<sup>3</sup>&nbsp;Data from the Bureau of Labor Statistics.</span></p>
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Mon, 14 Jul 2014 15:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/oil-prices-fracking.htmlOil Prices: Fracking to the Rescue?<div class="everything">
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<h3><i>Rising domestic oil and gas production has held energy prices in check. But it could be a different story if Middle East supplies are severely disrupted.</i></h3>
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<p>For now, it looks as though fracking has saved the U.S. economy’s recovery.&nbsp; Were it not for the impressive increase in North American oil and gas production, the current hostilities in Iraq would have driven up global oil prices to $130–140 a barrel,<sup>1</sup> a level that could easily have stopped &nbsp;the United States’ already inadequate economic recovery, driven Europe back deeper into recession, and slowed growth elsewhere in the world, if not thwarted it altogether.&nbsp; This, however, is only the beginning.&nbsp; If North American energy sources have quelled fears about shortages and kept down prices, Iraq’s troubles could become much worse.&nbsp; They have as yet, however, had little effect on oil flows throughout the Persian Gulf.&nbsp; Should they, North American production would not be able to fill the gap, the price of a barrel would rise, and those higher prices would have their ill effects on economies worldwide.&nbsp;</p>
<p><b>It’s Not about Energy Independence<br>
</b>Contrary to much comment in the media, the relief from fracking in the United States has little to do with energy independence.&nbsp; Perhaps this concept would have meaning if the United States were involved in a global war, as it was twice during the twentieth century.&nbsp; But short of such an all-consuming conflagration, whether this country can produce enough for its own needs or not means less than how much it is adding to or drawing on the world’s precious supply of energy.&nbsp; Oil’s price is set on a global market, and all players, however much they produce, pay the global prices.&nbsp; Some years ago, for example, when North Sea oil made the United Kingdom a net oil exporter, people there still paid global price, and when there were disruptions of supplies from the Middle East, the United Kingdom paid the higher global price, as did all other countries. &nbsp;</p>
<p>Rather than address questions of energy independence, what U.S. and Canadian oil production have done to blunt the immediate impact of this horrible situation is to make a significant difference in <i>global</i> supplies.&nbsp; More specifically, they have more than offset declines in Mexican and the North Sea production.&nbsp; Table 1 makes this relationship clear.&nbsp; Flows from Norwegian, U.K., and Mexican sources fell by some 1.002 million barrels a day, from the beginning to the present recovery in 2009, while U.S. and Canadian production rose by 3.548 million barrels a day.&nbsp; They constitute 81.2% of the entire 4.382 million-barrel a day increase in global supplies during this time.</p>
<hr class="separator_grey">
<p><b><span class="rte_txt_green">Table 1. Oil Production in Recent Years, Selected Sources</span><br>
</b><i>(000s of barrels per day)</i></p>
<table class=no_style border="0" cellspacing="0" cellpadding="0" width="570">
<tbody><tr><td width="96" valign="top"><p>&nbsp;</p>
</td>
<td width="72" valign="top"><p><b>World</b></p>
</td>
<td width="102" valign="top"><p><b>Persian Gulf</b></p>
</td>
<td width="69" valign="top"><p><b>Russia</b></p>
</td>
<td width="75" valign="top"><p><b>U.K.</b></p>
</td>
<td width="77" valign="top"><p><b>Norway</b></p>
</td>
<td width="77" valign="top"><p><b>Mexico</b></p>
</td>
<td width="77" valign="top"><p><b>Canada</b></p>
</td>
<td width="75" valign="top"><p><b>U.S.</b></p>
</td>
</tr><tr><td width="96" valign="top"><p>2009</p>
</td>
<td width="72" valign="top"><p>72,609</p>
</td>
<td width="102" valign="top"><p>20,754</p>
</td>
<td width="69" valign="top"><p>9,495</p>
</td>
<td width="75" valign="top"><p>1,328</p>
</td>
<td width="77" valign="top"><p>2,067</p>
</td>
<td width="77" valign="top"><p>2,646</p>
</td>
<td width="77" valign="top"><p>2,579</p>
</td>
<td width="75" valign="top"><p>5,353</p>
</td>
</tr><tr><td width="96" valign="top"><p>2010</p>
</td>
<td width="72" valign="top"><p>74,378</p>
</td>
<td width="102" valign="top"><p>21,589</p>
</td>
<td width="69" valign="top"><p>9,694</p>
</td>
<td width="75" valign="top"><p>1,233</p>
</td>
<td width="77" valign="top"><p>1,869</p>
</td>
<td width="77" valign="top"><p>2,621</p>
</td>
<td width="77" valign="top"><p>2,741</p>
</td>
<td width="75" valign="top"><p>5,471</p>
</td>
</tr><tr><td width="96" valign="top"><p>2011</p>
</td>
<td width="72" valign="top"><p>74,489</p>
</td>
<td width="102" valign="top"><p>22,953</p>
</td>
<td width="69" valign="top"><p>9,774</p>
</td>
<td width="75" valign="top"><p>1,026</p>
</td>
<td width="77" valign="top"><p>1,752</p>
</td>
<td width="77" valign="top"><p>2,600</p>
</td>
<td width="77" valign="top"><p>2,901</p>
</td>
<td width="75" valign="top"><p>5,652</p>
</td>
</tr><tr><td width="96" valign="top"><p>2012</p>
</td>
<td width="72" valign="top"><p>75,868</p>
</td>
<td width="102" valign="top"><p>23,214</p>
</td>
<td width="69" valign="top"><p>9,922</p>
</td>
<td width="75" valign="top"><p>888</p>
</td>
<td width="77" valign="top"><p>1,607</p>
</td>
<td width="77" valign="top"><p>2,593</p>
</td>
<td width="77" valign="top"><p>3,108</p>
</td>
<td width="75" valign="top"><p>6,484</p>
</td>
</tr><tr><td width="96" valign="top"><p>2013</p>
</td>
<td width="72" valign="top"><p>76,039</p>
</td>
<td width="102" valign="top"><p>23,010</p>
</td>
<td width="69" valign="top"><p>10,049</p>
</td>
<td width="75" valign="top"><p>810</p>
</td>
<td width="77" valign="top"><p>1,530</p>
</td>
<td width="77" valign="top"><p>2,562</p>
</td>
<td width="77" valign="top"><p>3,324</p>
</td>
<td width="75" valign="top"><p>7,447</p>
</td>
</tr><tr><td width="96" valign="top"><p>2014 (YTD)</p>
</td>
<td width="72" valign="top"><p>76,981</p>
</td>
<td width="102" valign="top"><p>23,465</p>
</td>
<td width="69" valign="top"><p>10,147</p>
</td>
<td width="75" valign="top"><p>869</p>
</td>
<td width="77" valign="top"><p>1,627</p>
</td>
<td width="77" valign="top"><p>2,543</p>
</td>
<td width="77" valign="top"><p>3,492</p>
</td>
<td width="75" valign="top"><p>8,018</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Energy Information Administration (EIA).</span></p>
<hr class="separator_grey">
<p><b>More Reliable Supplies, Plus Hope &nbsp; &nbsp; &nbsp;&nbsp;<br>
</b>Perhaps even more significant in the current context than the straightforward impact on supply is the hope for more reliable energy sources engendered by this surge in North American production.&nbsp; The basis for such hope is apparent in Table 2, which shows the percent of world production accounted for by each significant producer.&nbsp; The Persian Gulf as an oil source actually has become slightly more important.&nbsp; That hardly speaks to reliability.&nbsp; But Canada has gained dramatically as a global supplier, while the United States has soared.&nbsp; The headlines boast that this country is now a bigger producer than Saudi Arabia, but more significant is that it is now more than one-third the size, in terms of production, of the entire Persian Gulf region, which includes Saudi Arabia, Kuwaiti, Iraq, Iran, the United Arab Emirates, and lesser suppliers, such as Bahrain and Qatar.&nbsp; These relative gains do show a shift in world production toward more reliable sources.&nbsp; To be sure, the United Kingdom, Norway, and even Mexico were reliable as their importance has declined, but with the rise of Canada and the United States, the more reliable sources as a group have risen to more than one-fifth of the world’s supply and more than half the size of the Persian Gulf. &nbsp;</p>
<hr class="separator_grey">
<p><b><span class="rte_txt_green">Table 2. Percent Distribution of World Oil Production, Selected Sources</span></b></p>
<table class=no_style border="0" cellspacing="0" cellpadding="0" width="645">
<tbody><tr><td width="91" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="102" valign="top"><p><b>Persian Gulf</b></p>
</td>
<td width="72" valign="top"><p><b>Russia</b></p>
</td>
<td width="75" valign="top"><p><b>U.K.</b></p>
</td>
<td width="77" valign="top"><p><b>Norway</b></p>
</td>
<td width="77" valign="top"><p><b>Mexico</b></p>
</td>
<td width="75" valign="top"><p><b>Canada</b></p>
</td>
<td width="75" valign="top"><p><b>U.S.</b></p>
</td>
</tr><tr><td width="91" valign="top"><p>2009</p>
</td>
<td width="102" valign="top"><p>28.5%</p>
</td>
<td width="72" valign="top"><p>13.2%</p>
</td>
<td width="75" valign="top"><p>1.8%</p>
</td>
<td width="77" valign="top"><p>2.8%</p>
</td>
<td width="77" valign="top"><p>3.6%</p>
</td>
<td width="75" valign="top"><p>3.6%</p>
</td>
<td width="75" valign="top"><p>7.3%</p>
</td>
</tr><tr><td width="91" valign="top"><p>2010</p>
</td>
<td width="102" valign="top"><p>29.0</p>
</td>
<td width="72" valign="top"><p>13.0</p>
</td>
<td width="75" valign="top"><p>1.7</p>
</td>
<td width="77" valign="top"><p>2.5</p>
</td>
<td width="77" valign="top"><p>3.5</p>
</td>
<td width="75" valign="top"><p>3.7</p>
</td>
<td width="75" valign="top"><p>7.3</p>
</td>
</tr><tr><td width="91" valign="top"><p>2011</p>
</td>
<td width="102" valign="top"><p>30.8</p>
</td>
<td width="72" valign="top"><p>13.1</p>
</td>
<td width="75" valign="top"><p>1.4</p>
</td>
<td width="77" valign="top"><p>2.4</p>
</td>
<td width="77" valign="top"><p>3.5</p>
</td>
<td width="75" valign="top"><p>3.9</p>
</td>
<td width="75" valign="top"><p>7.6</p>
</td>
</tr><tr><td width="91" valign="top"><p>2012</p>
</td>
<td width="102" valign="top"><p>30.6</p>
</td>
<td width="72" valign="top"><p>13.1</p>
</td>
<td width="75" valign="top"><p>1.2</p>
</td>
<td width="77" valign="top"><p>2.1</p>
</td>
<td width="77" valign="top"><p>3.4</p>
</td>
<td width="75" valign="top"><p>4.1</p>
</td>
<td width="75" valign="top"><p>8.5</p>
</td>
</tr><tr><td width="91" valign="top"><p>2013</p>
</td>
<td width="102" valign="top"><p>30.2</p>
</td>
<td width="72" valign="top"><p>13.2</p>
</td>
<td width="75" valign="top"><p>0.7</p>
</td>
<td width="77" valign="top"><p>2.0</p>
</td>
<td width="77" valign="top"><p>3.4</p>
</td>
<td width="75" valign="top"><p>4.4</p>
</td>
<td width="75" valign="top"><p>9.8</p>
</td>
</tr><tr><td width="91" valign="top"><p>2014(YTD)</p>
</td>
<td width="102" valign="top"><p>30.5</p>
</td>
<td width="72" valign="top"><p>13.2</p>
</td>
<td width="75" valign="top"><p>0.7</p>
</td>
<td width="77" valign="top"><p>2.1</p>
</td>
<td width="77" valign="top"><p>3.3</p>
</td>
<td width="75" valign="top"><p>4.5</p>
</td>
<td width="75" valign="top"><p>10.4</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Energy Information Administration (EIA). </span>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<hr class="separator_grey">
<p>There is something else that is moderating the price effect during this latest trouble in the Middle East.&nbsp; Unlike past times of supply interruptions or threatened interruptions, market participants this time have reason to hope, even expect, not just an increase in future global supply but also a continued shift in the direction of more reliable sources.&nbsp; The impressive growth of production in Canada (35%, between 2009 and the present) and the United States (nearly 50%) is a significant part of that expectation, especially since indicators point to continued growth at such remarkable paces.&nbsp; By contrast, Persian Gulf output has increased only 13% during this time, largely because of the development of Iraqi oil after the last bout of fighting and modernization of some Saudi production facilities.&nbsp; Neither of these, however, are likely to be repeated going forward.&nbsp; Though that prospect suggests slower growth in global supplies than otherwise, it does suggest a decrease in the significance in this volatile and unreliable region.</p>
<p>Giving hope especially is that there is a greater such shift in prospect.&nbsp; Because fracking enables drillers to extract oil and gas from shale, all the world’s shale deposits now offer promise, when only a few years ago they hardly factored into the global supply equation at all.&nbsp; Some nations, such as France, resist the drilling, as do some individual states in the United States, but market participants account for the promise anyway, and do so on the assumption that an energy shortage would change such attitudes.&nbsp; Meanwhile, Australia, which has no such reluctance about drilling, recently announced a huge shale find that, if preliminary reports are to be believed, could increase global oil and gas supplies by some 13%.&nbsp; Coming years also should see production from Brazil’s large, conventional oil find in the South Atlantic and the promising exploration Exxon is now doing in the Russian Arctic.&nbsp; Russia, to be sure, hardly counts as a reliable source (with its temperamental, nearly autocratic government), but the increased supply will come to market nevertheless.&nbsp; Of course, these future sources are not available now, but oil prices, just like those in every financial and commodity market, reflect prospects and risks as much as basic current supply and demand, and these positive developments weigh in market calculations against the risk that turmoil in Iraq could cut off other supplies in the future. &nbsp; &nbsp;&nbsp;</p>
<p><b>The Danger Cannot Be Easily Written Off &nbsp;&nbsp;<br>
</b>Still, there is no mistaking the huge importance of Persian Gulf supplies.&nbsp; If the turmoil there were suddenly to take those supplies, or a significant portion of them, off line, the world would be hard pressed to replace those sources, and prices would rise with all their ill effects.&nbsp; What is more, the Persian Gulf itself is also a choke point of no small significance in oil transport.&nbsp; If production is a significant 30.5% of world output, upwards of 35% of seagoing oil and gas transport passes through the Gulf and the narrow Strait of Hormuz at its head.&nbsp; If Iran were to become further embroiled in Iraq’s problems, or otherwise come to a confrontation with Western powers, the strait would close and the world would find itself without any of this still crucial supply.&nbsp; To be sure, the U.S. Navy has a major presence in the Gulf, and it claims that it could prevent any such closure of the strait.&nbsp; But even if the navy could hold Iran’s forces at bay, the strait would close anyway, for the still significant threat to shipping would prompt insurers either to refuse to cover cargos in the Gulf or raise premiums to unsupportable levels.</p>
<p>For the time being, though, markets have stood up well in the situation.&nbsp; Shipments continue even from Iraq—and certainly from Kuwaiti, Saudi Arabia, Iran, the Emirates, and other sources—and even as the rise of reliable sources outside the region disarms fears of any additional disruption.&nbsp; But given the continued importance of Gulf oil supplies in general and of the Gulf as a shipping lane, an expansion of this turmoil still threatens to overwhelm the confidence built on Canadian and U.S. supplies, and to raise oil prices, and, accordingly, to impede economic growth in general.&nbsp; &nbsp;</p>
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Mon, 14 Jul 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/can-the-us-economy-regain-its-old-glory.htmlCan the U.S. Economy Regain Its Old Glory?<div class="everything">
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<h3><i>Here’s what needs to happen for U.S. growth to rise above its multiyear muddle.</i></h3>
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<p>Financial advisors, as well as their clients, frequently ask what will get the United States back to its higher, historical growth rate. The fear is that the disappointing pace of this recovery so far is somehow a &quot;new normal.&quot; &nbsp;Longer term, aging demographics may indeed impose a slower-trend growth rate on this economy. But for a two- to four-year horizon, a return to a higher pace of growth is entirely possible if two things happen: 1) Corporate America sheds its fear that has gripped it since the 2008–09 &quot;great recession&quot; and 2) the economy as a whole and its business sector in particular find clarity in Washington.</p>
<p><b>The Recession's Lingering Effect<br>
</b>The Great Recession clearly has had a lasting and unfavorable effect. The severity of the downturn and the accompanying financial dislocation had put so many in danger that company managements, even now five years later, avoid any risk that could place them back in the former difficulties.&nbsp; No statistics exist, but anecdotal evidence indicates that many firms had trouble meeting payroll in 2009, and when they went to the bank to draw on what they believed was a secure line of credit, many were denied.&nbsp; Little wonder, then, that managements since have remained so reluctant to hire or spend at all for that matter. So unlike past recoveries, when industry hired at a rate of 300,000–400,000 a month, this time they have hired at a rate of closer to 200,000 a month.<sup>1</sup> Spending on new capital equipment and facilities is similarly stunted.&nbsp; The caution also shows in the size of corporate cash holdings. According to the Federal Reserve, non-financial corporations presently hold close to $1.5 trillion in cash and cash equivalents, a large number by any standard, about 15% of total liabilities, in fact, and well above historical norms in both absolute and relative terms.</p>
<p>Time is probably the only cure for this growth retardant. Only when these clearly deep wounds heal will managements regain enough aggressiveness, what the great economist John Maynard Keynes called &quot;animal spirits,&quot;<sup>2</sup> to push up hiring and spending and so to propel the economy at its historical growth rate of more than 3%.<sup>3</sup> It is an open question how much time it will take, though it is apparent from the last five years of the subpar recovery that the change will wait a while longer. This year has, though, brought a sign that managements are at least&nbsp; beginning to become more aggressive.&nbsp; Mergers and acquisitions have risen dramatically. Year to date, approximately $700 billion has changed hands in such endeavors.<sup>4</sup>&nbsp;Still, it will take a while for these tentative, initial signs to bring the increased rates of hiring and capital spending that could propel the economy at its former, higher growth pace.&nbsp;</p>
<p><b>The Legislative Effect &nbsp; &nbsp; &nbsp;<br>
</b>Complex legislation passed by Washington in 2010 has also created a drag on the rate of economic growth. It is not so much whether the Affordable Care Act or the Dodd-Frank financial reform legislation are good or bad bills. Even if they were brilliant, and that is debatable, their sweeping nature and complexity have generated considerable uncertainty, particularly among business managers, that has compounded the growth-retarding influence of the Great Recession.<sup>4</sup> It is not just because the thousands of pages of either bill are difficult to interpret but also because Washington’s regulators have yet to write the thousands of rules required to implement the laws. According to a recent CNBC report, even now almost four years after the bill's passage, 243 rules outlined in Dodd-Frank's 3,200 pages have yet to be written. The Affordable Care Act looks little different, and this failing includes neither outstanding court cases surrounding the legislation nor its suspended and temporarily modified aspects. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p>Until all those points become clear, managers will remain doubtful about the future availability and cost of credit, on the one hand, and the cost of hiring a new employee on the other. Even if the ultimate assessment is increased costs, that certain knowledge would do less harm than the uncertainty that has surrounded these bills since their passage, and that makes managements err on the side of caution. There was some hope that the scheduled 2014 implementation of the Affordable Care Act would bring a welcome degree of clarity, but both the lawsuits and all the temporary adjustments in the law have dashed any such hope and promise to postpone clarity for at least another 12–18 months.</p>
<p><b>Net Conclusion: Little Change &nbsp;&nbsp;<br>
</b>The economy has held up under these negatives for some time. The negatives have slowed but not stopped the recovery. They are unlikely to cause any worse damage going forward.&nbsp; But at the same time, they are unlikely to lift anytime soon either; but should they begin to do so, any relief will likely emerge slowly indeed. The only conclusion, then, is continued growth, but at the subpar pace of this recovery so far. Chances of an acceleration, either because the memories of past pain fade or because business at last makes sense of Washington’s legislation, look poised to wait until 2015 at the earliest and possibly even longer.&nbsp;</p>
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Mon, 7 Jul 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/manufacturing-who-will-win-the-world-cup.htmlManufacturing: Who Will Win the World Cup?<div class="everything">
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<h3><i>Emerging economies now dominate production of lower-value goods. But the United States and other developed nations have a solid lead in the higher end.</i></h3>
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<p>Americans these days seem to eye emerging economies with increased suspicion, even fear. Just as they once worried over Japan’s economic strength, the prevalent impulse is to see American decline in each stride made by China, India, Brazil, and other such burgeoning nations. In some ways, such feelings are reasonable. These emerging economies are growing fast, and they are displacing American production in many areas. The broader picture, however, is both more complex and less threatening.</p>
<p>What is happening is less the feared power shift than a natural division of production across the globe, completely in accordance with economic laws, and reflecting the relative strengths and weaknesses of these very different economies. Simpler, labor-intensive sorts of production are migrating naturally to emerging economies, where there are large, youthful workforces that are cheap, but poorly trained and supported. While this shift has forced difficult adjustments on classes and regions of the United States and other developed economies, it does not, as too many believe, speak to economic decline. On the contrary, this country and other advanced economies are doing more to get the best use of their expensive, limited, but well-trained and well-supported workers by concentrating on the production of complex, high-value goods and services.</p>
<p><b>A Macro Check on the Fear Scenario &nbsp; &nbsp; &nbsp;<br>
</b>Broad-based statistics bear out this interpretation of the trends. Here, the relevant measure is less the overall output, exports, or total manufacturing and more the value added by each economy. These measures can vary widely. Overall, Chinese manufacturing looms large, but such statistics fail to consider how much China imports to create its output, such as raw materials, parts, certainly the machinery used in the production process. A finished iPad from China, for instance, includes much intellectual capital and parts produced in the United States. The equipment used in the iPad’s assembly comes from Apple and is also largely designed and made in the United States. The only part China adds is the relatively simple, if painstaking process of assembly. The United States, in contrast, adds almost all the value to its manufactures and exports—the raw materials, the parts, and, of course, the machinery used in the process. &nbsp; &nbsp;&nbsp;</p>
<p>A recent paper from the National Bureau of Economic Research offers telling data on these differences. Though the study was completed in 2010, it is still the only comprehensive work on offer. Anecdotal evidence suggests that it still captures the reality of the situation. Table 1 reproduces the relevant figures. The developed countries are all fairly similar in this respect, producing almost 90% of their exports from domestic sources of one kind or another. Russia produces the most domestically, but this is a bit misleading, since such a large part of that economy’s exports are raw materials, mostly oil and gas. In contrast and tellingly, China’s domestic sourcing is notably lower, as is India’s, though not to the extreme exhibited by China.</p>
<p><b>A More Detailed Look at Trade and Production Patterns<br>
</b>Detail on particular industries fills in the picture and confirms the natural division of production. China’s own government acknowledges the division, describing the country’s entire industrial effort as oriented toward “traditional, labor-intensive sectors such as spectacles, ornaments, shoes, and [retail] electronic goods.”<sup>1</sup>&nbsp; India, too, for all the noteworthy progress that economy has made upgrading its production effort, has actually increased its bias toward low-value-added, labor-intensive products as the country’s integration into the global economy has proceeded. In the last 35 years, sales of these sorts of products have risen from 34% of India’s total exports to 45%.<sup>2</sup></p>
<p><span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Table 1. Domestically Produced Value Added in Manufacturing Exports Selected Economies</span><br>
</b>(% of total exports)</p>
<table class=no_style border="1" cellspacing="0" cellpadding="0">
<tbody><tr><td width="213" valign="top"><p>&nbsp;</p>
</td>
<td width="213" valign="top"><p><b>Domestic Value Added</b></p>
</td>
<td width="213" valign="top"><p><b>Foreign Value Added</b></p>
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</tr><tr><td width="213" valign="top"><p><b>United States</b></p>
</td>
<td width="213" valign="top"><p>87.1%</p>
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<td width="213" valign="top"><p>12.9%</p>
</td>
</tr><tr><td width="213" valign="top"><p><b>EU</b></p>
</td>
<td width="213" valign="top"><p>88.5</p>
</td>
<td width="213" valign="top"><p>11.5</p>
</td>
</tr><tr><td width="213" valign="top"><p><b>Japan</b></p>
</td>
<td width="213" valign="top"><p>87.8</p>
</td>
<td width="213" valign="top"><p>12.2</p>
</td>
</tr><tr><td width="213" valign="top"><p><b>China</b></p>
</td>
<td width="213" valign="top"><p>63.6</p>
</td>
<td width="213" valign="top"><p>36.4</p>
</td>
</tr><tr><td width="213" valign="top"><p><b>India</b></p>
</td>
<td width="213" valign="top"><p>80.0</p>
</td>
<td width="213" valign="top"><p>20.0</p>
</td>
</tr><tr><td width="213" valign="top"><p><b>Russian Federation</b></p>
</td>
<td width="213" valign="top"><p>89.9</p>
</td>
<td width="213" valign="top"><p>10.1</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Robert Koopman, William Powers, Zhi Wang, and Shang-Jin Wei, &quot;Give Credit Where Credit Is Due: Tracing Value Added in Global Production Chains,&quot; working paper 16426, National Bureau of Economic Research, September 2010; calculations made using Department of Commerce and other data.</span></p>
<p><span class="separator">&nbsp;</span></p>
<p>The dominant industries in each economy paint the same picture. More than half of India’s exports lie in textiles, garments, and handicrafts—the quintessential simple, labor-intensive output. Almost 80% of that country’s industrial workforce is employed in textiles.<sup>3</sup>&nbsp;China reports more than 100 million of its workforce directly or indirectly employed in the industry, 12.5% of the total.<sup>4</sup> The story is the same for other emerging economies.&nbsp; Some 53% of Sri Lanka’s exports, for example, are in garments or textiles. For Bangladesh, the figure is 95%, for Laos, 93%; and for Vietnam, 90%.<sup>5</sup> At the same time, these emerging economies import almost all the high-value items they use. When it comes to semiconductors and microprocessors, China is almost entirely import-dependent. It also imports most of its nuclear fuel, chemicals, metals, specialty electrical goods, telecommunications products, and transportation equipment.<sup>6</sup> China’s export effort is so dependent on imported inputs that they rise and fall in lockstep with the country’s exports. India, though it produces 92% of labor-intensive products for itself, imports 44% of its machinery and technology.<sup>7</sup> Brazil shows a similar mix.<sup>8</sup></p>
<p>Even when these economies claim production in areas usually described as high tech or high value, their output leans toward the cheaper, simpler side of the category. According to one prominent researcher, most of China’s so-called “high-tech” exports are “high-volume, commodity-like product[s] sold primarily by mass merchandisers.”<sup>9</sup> If India does a lot of business in software development, all, according to other research, lies in areas “too limited for anything sophisticated.”<sup>10</sup> The country’s pharmaceuticals lean toward generics and the output of straight-forward active ingredients, what the industry calls “bulk drugs.”<sup>11</sup> Brazil’s otherwise impressive pharmaceutical industry follows the same pattern.<sup>12</sup> When it comes to services, which include India’s famed call centers, emerging economies focus entirely on simpler retail support. More sophisticated consulting, especially for business and government, still comes largely from developed economies. For all the headlines, it is noteworthy that U.S. and U.K. consulting net, then, three times as much revenue as India’s efforts and 12 times China’s.<sup>13</sup></p>
<p><b>A Longer View<br>
</b>Such divisions should persist for a long while, too. According to <i>The Economist</i>, the average Chinese worker has only 5% of the equipment and computing power at his or her disposal that the equivalent worker in developed economies has. Though China, India, and other emerging economies produce impressive scientists, engineers, entrepreneurs, and artists, the bulk of their workforces is far less educated and less well trained than their counterparts in the developed economies. According to statistics from the United Nations and the CIA, the average worker in China has barely 6.4 years of schooling. In India, the figure is 5.1 years, and in Brazil, 4.9 years. In contrast, the average worker in the United States has 13.1 years of schooling, in Japan, 9.5 years, and in Europe, eight to 10 years. Literacy in the developed world exceeds 99% of the adult population. In China, the rate equals barely 91%, in Brazil, 89%, and in India, 61%. It will take decades for such differences to disappear, not the least because less-well-educated workers from the countryside continue to flow into the workforces of these emerging economies.</p>
<p>Still, there is no room for complacency. The need in developed economies to focus on high value will impose an intense need to upgrade continually. Innovation will become even more important. No doubt, partnerships between government, industry, and universities will become more common, perhaps re-approaching the scale used during the Cold War and the Space Race of the 1960s. To encourage private innovation further, government at all levels will need to implement incentives, grants, to be sure, but also efforts to streamline regulations and modify the tax system to allow innovators to keep the fruit of their efforts. The associated need for high levels of training and education will also draw out unprecedented efforts, both private and public. These will not only feed the needs of the more innovative, high-value economy but also help those workers who have lost work in simpler industries to transition to the new, more high-value, sophisticated economic focus. The net effect—far from the fears and anxieties that dominate current discussions on the subject—actually promises considerable opportunity.</p>
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Mon, 30 Jun 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-housing-a-slow-building-recovery.htmlU.S. Housing: A Slow-Building Recovery<div class="everything">
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<h3><i>While new-home sales have seen a weather-related boost, higher mortgage rates and rising prices could temper the rebound.</i></h3>
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<p>Housing appears to have begun its spring rebound from the weather-induced shortfalls earlier in the year. Sales of new homes jumped 6.4% in April. Contractors increased starts of new homes by a whopping 8.0%.<sup>1</sup> It is good to get confirmation that the poor figures of last winter were indeed weather-induced and not a new negative trend. But it also would be a mistake to extrapolate this rebound into an outlook for too much strength. The fundamentals behind the housing market suggest neither decline nor acceleration, but rather a slow slog back. &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Hints in the Detail<br>
</b>This conclusion emerges from the mix of new home construction. The biggest part of the April surge occurred in multifamily homes, those consisting of five or more units. These rose 21.8% in that month alone. This speaks loudly to the effects of weather. Because these larger buildings use disproportionately more concrete, they are particularly weather sensitive. Construction of these structures fell 23% during the worst of the cold and storms late in 2013 and earlier this year. In contrast, single-family home construction fell a relatively modest 4.3% during the worst of the weather and rose only 0.3% in April.&nbsp;</p>
<p>The regional distribution of construction tells the same story. The biggest April recovery occurred in the South. It is not that the South had more severe weather than the Northeast or the Midwest—far from it, in fact. But the severe winter brought frosts to a region that usually is free of them altogether, something for which the normal seasonal adjustment patterns could not account. On a seasonally adjusted basis, then, the biggest spring rebound was likely there. Sales patterns also reflect weather effects. The largest rebound occurred in the Midwest, where, of course, the especially bitter cold of winter had kept buyers away in far greater numbers than are built into the normal seasonal adjustments, making the warmer-weather recovery look strongest there. &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Factors That Will Temper the Rebound<br>
</b>The array of other more fundamental influences points to continued, but much slower improvements. First on the list is the rise in mortgage rates. According to the National Association of Realtors (NAR), in the past 12 months the average mortgage rate rose by 72 basis points, from 3.66% in March 2013 to 4.38% this past March (the most recent month for which data are available). At the same time, the price of homes has risen.&nbsp; Again using the NAR data, the sale price of an existing home nationally rose 7.6% during this 12-month period. To be sure, rising real estate prices can cut two ways. On the one side, they instill in potential buyers confidence that real estate is a good investment. On the other, they make it harder to finance the purchase. After the financial shocks of 2008–09, it may yet take a while before rising real estate prices have the first, more positive effect. In the meantime, the rising price, plus the increase in mortgage rates, has increased the cost of carrying a mortgage by 17.2% during the past year.</p>
<p><b>Factors That Will Sustain a Recovery in Housing &nbsp; &nbsp;&nbsp;<br>
</b>At the same time, there is enough positive data to expect at least a moderate continued expansion. If the positive aspect of real estate price increases is a less powerful motivator than it once was, the rise in mortgage rates is hardly enough to shut down buyers. Rates remain low by historical standards. On an aftertax basis, even the new, higher 4.38% mortgage rate is barely above the rate of inflation. The real cost of financing remains near zero, if not below it. To be sure, the increased price of real estate, combined with the increased financing costs, has caused the NAR's Affordability Measure to deteriorate by 13% since last spring. Even so, housing today remains 20% more affordable than during most of the 1990s and early 2000s. &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>The pattern of new household formation also factors in here, largely on the positive side. According to the Consensus Bureau, household formation in the United States dropped off precipitously during the 2008–09 recession and has only recovered modestly since, largely because hiring in this recovery has trailed historical averages. These government statistics show that some 45% of 18- to 30-year-olds live with older family members, well up from historical norms of 35–39%. Household formation has, accordingly, averaged only about 550,000 a year since 2009, well below the 1.35 million averaged between 2000 and 2006. This circumstance naturally has held back housing demand throughout this time. If employment picks up, even modestly, household formation will likely rise in tandem, with clearly favorable effects on housing demand, largely through rentals probably. But even if the pace of employment growth remains as anemic as it has been, it is unlikely that the pace of household formation will fall further. &nbsp; &nbsp;</p>
<p><b>Net Prospects<br>
</b>The fundamentals are sufficient enough to promote a continued recovery. The unfavorable influences seem set to hold back the pace of gain, in sales, in construction, and in real estate prices. It is a pattern typical of other sectors of the economy in this generally disappointing recovery. For residential real estate, then, as for those other sectors of this economy, the prospect is for only moderate expansion, a continued slow slog back, and a long time before housing can become the great engine of growth it once was—or a bubble threat.</p>
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Mon, 23 Jun 2014 09:45:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/europe-draghis-deflation-defense.htmlEurope: Draghi's Deflation Defense<div class="everything">
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<h3><i>The European Central Bank’s latest policy moves are a holding action until real economic and fiscal reform can take hold.</i></h3>
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<p>Europe’s financial crisis seems to have quieted. It is a strange development, for the eurozone is beginning to face a new threat to its financial stability. Signs of inordinately low inflation and possibly even deflation have begun to compound all the debt and policy problems that have bedeviled the eurozone for over four years. To meet this new challenge, the European Central Bank (ECB) has promised action, but there is only so much it can do. Monetary policy, even of the most energetic kind, cannot ultimately answer Europe’s needs. The best the ECB can do is buy time for member nations to implement fundamental economic and fiscal reform, especially in regulatory, labor, and product market policies. Without this (or extraordinary good luck), Europe's problems can only become worse.&nbsp;</p>
<p><b>The New Complication<br>
</b>The deflationary threat is clear. Recent reports show zone-wide inflation trending at below 1.0%, far below the ECB’s target of 2.0%. In Ireland and other countries of Europe’s troubled periphery, reports already point to outright deflation. Inflation has its own evils, but that does not mean deflation is harmless. On the contrary, it carries a dual threat. On an economic level stands the warning of Japan, where deflation has contributed to two decades of stagnation. On the financial side, deflation raises the already great risk of default, for falling price levels would make future real payments on Europe’s already outsized debt load that much more onerous, something these already beleaguered nations can ill afford.<sup>1</sup>&nbsp; &nbsp;&nbsp;</p>
<p>With both these concerns in mind, but especially the implicit risk of default, the ECB atypically has promised bold action. President Mario Draghi about a month ago promised “extraordinary measures” to guard against deflation, describing the bank as willing &quot;to act swiftly if required.&quot; He alluded to the possibility of outright asset purchases (commonly called qualitative easing)—a major shift from his past reluctance, especially since the U.S. Federal Reserve and the Bank of England are beginning to unwind their quantitative-easing programs. Draghi just last week also lowered some interest rates into negative territory. Following a policy previously used in Denmark, his thought is that deflation would have more difficulty taking root if banks lent more freely to businesses and individuals, and he is convinced that they would do so if instead of paying them interest on the spare reserves they keep on deposit at the ECB, they actually had to pay a charge on them.<sup>2</sup>&nbsp; &nbsp; &nbsp;</p>
<p>The pressure on Draghi and the ECB is that much greater because low inflation has already blunted the stimulative effect of past policy efforts. To date, the ECB has relied mostly on low interest rates to relieve the strain on debtor nations and to generally reliquefy the financial system. But with each notch down in inflation, those rates look less low in real terms. In 2012, for instance, when the ECB held short-term interest rates at 1.5%, zone-wide inflation averaged 2.5%. The real expense of borrowing that year was actually a negative 1.0%. But in the intervening period, during which interest rates have fallen an additional by half a percentage point, the annual rate of inflation has fallen by almost two percentage points. The real cost of borrowing has accordingly risen out of negative territory, still low by broad historical standards, but clearly much less supportive than it was two years ago.<sup>3</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Only So Much the ECB Can Do<br>
</b>Even if the ECB performs brilliantly and stems the deflationary tide, it can still only offer Europe partial relief.&nbsp; The best any monetary policy can do in Europe’s situation is to create a period of relative financial calm and reduced borrowing costs in order to give debtor nations time to reorder their finances, presumably through a combination of economic growth and fiscal austerity. The ECB, in other words, has only ever offered deeply indebted nations a kind of low-rate bill-payer loan, such as households use to avoid bankruptcy while they get their finances in order. Just like a bill-payer loan, however, such palliatives fail unless the recipients use the time to cut spending or increase income (grow in a nation’s case) or both. It was always a precarious effort now made considerably more difficult by the prospect of deflation. &nbsp; &nbsp;&nbsp;</p>
<p>If anything, then, this latest, deflationary twist Europe’s crisis saga makes austerity and fundamental, pro-growth reform that much more urgent. Just like the household clinging to its bill-payer loan, these nations cannot abandon fiscal austerity. Some, most particularly France, have floated the idea of giving up on austerity to use government spending as a way to produce some growth momentum. Though it is true that fiscal austerity stymies growth, such an approach would ultimately defeat itself. Any letup in fiscal discipline would signal markets of a new flow of debt on top of an already huge existing supply. Bond buyers, investors, and bankers would become that much more wary. Default fears would gain greater currency. Markets would become less stable. Governments would quickly find it more expensive to finance their fiscal ease. &nbsp; &nbsp; &nbsp;</p>
<p><b>Europe’s Only Real Option<br>
</b>If that became the case, then, the nations of the eurozone have but two options. One is to hope that somehow, with no additional policy effort, the economic situation will improve and promote enough growth to make the existing debt overhang supportable. This appears to be the French approach. The other option is to implement pro-growth fundamental reforms, even as the eurozone nations adhere to fiscal austerity. Such reform efforts have gone in and out of fashion among Europe’s periphery during these past four years of crisis. Now, as once before, those who would seek such change are watching the latest Italian experiment. &nbsp; &nbsp;</p>
<p>A couple of years ago, Italy, under its interim prime minister, Mario Monti, charted this necessary course.&nbsp; Acknowledging the need for continued fiscal austerity, but recognizing that the nation could never shoulder the existing debt burden without growth, he modeled his effort on successful German reforms of some years earlier, aiming to make Italian labor and product markets more flexible. Under pressure from the sovereign debt crisis and Italy’s desperation, Monti managed to enact labor market reforms that in prior years Italy had failed again and again to implement. These encourage job creation by making hiring and firing easier and less costly. By also allowing management more latitude to set work rules, his reforms promised more reliable growth by improving business’ ability to better cope with economic fluctuations. Politics, however, interfered. Monti was forced from office, and, consequently, the reform movement, if not rolled back, lost momentum. More recently, however, the country, still desperate, has revivified the effort. Its new prime minister, Matteo Renzi, campaigned on the need for such fundamental reform and recently announced a multiyear plan to promote long-term growth.<sup>4</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Whether Renzi and Italy can follow through is an open question. The country has already faltered once along this path. Still, it is reasonable that Italy should embrace this urgent need. Next to Greece, it was one of the Continent’s most deeply indebted nations, a major contributor to the crisis, and one of the most in need of debt relief. What happens with Renzi’s effort, then, has the power to create or destroy hope for Europe’s ultimate recovery, especially now in the face of deflation. But even if Rome fails, Europe still has options. Greece, Spain, Portugal, and even France have contributed mightily to the debt overhang that lies at the root of this crisis and have great potential to respond to the kinds of economic reforms adopted by Germany in the last decade and attempted by Italy more recently.</p>
<p>It would have a certain poetic quality if Italy, previously one of Europe’s leading examples of economic dysfunction, leads the Continent’s healing effort. But whether the Italians or some other peripheral nation takes the lead, the reform is urgent, especially now that the prospect of deflation makes it still more difficult for the ECB to buy time. If no one moves, as no one has sufficiently to date, the crisis will continue, while the monetary palliatives will become less and less effective as, indeed, the deflationary threat is already demonstrating.</p>
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Mon, 16 Jun 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-forward-reverse-or-neutral.htmlU.S. Economy: Forward, Reverse, or Neutral?<div class="everything">
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<h3><i>Optimism for economic acceleration has given way to concerns about a slowdown. What are the numbers really telling us?</i></h3>
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<p>Consensus opinion on the economy has flip-flopped more than usual this year. It came into the year optimistic about an acceleration in the pace of recovery. Perhaps this expectation took off from unusually positive comments made by the U.S. Federal Reserve. It had to be the rhetoric, for there was precious little evidence that such a prospect was likely, as Lord Abbett explained in a series of discussions in this spot on April 28 and May 5 and 12. Then in April, the U.S. Department of Commerce reported barely any growth during first quarter.<sup>1</sup> At first, the consensus dismissed the poor performance as purely weather related. But when subsequent figures, on retail sales and industrial production, among others, indicated that the much anticipated spring surge might not occur, consensus thinking began to worry about another economic downturn—a view as unwarranted as the earlier optimism. The fact is that the economy shows every sign of continuing the slow pace of growth that has typified the recovery so far.</p>
<p>Rather than repeat the arguments of earlier pieces, though they remain valid, this discussion looks at the releases that prompted this change in consensus thinking in order to see why they really still point to continued sluggish growth.&nbsp; <i>&nbsp;</i>&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>First is the 1.1% annualized decline in first quarter real gross domestic product (GDP). Some of this reading clearly reflected the inordinately severe weather that gripped the country in January and February 2014. The biggest effect, no doubt, was in construction. Real spending in nonresidential structures fell at an annual rate of 7.7%, and residential construction was certainly subdued compared with earlier in 2013. Given the sensitivity of construction to weather, there can be little doubt that the cold and storms factored into this picture. But the statistics reflected more than that. Residential and commercial construction had surged at an unsustainable rate in the middle quarters of the previous year, expanding, respectively, at annualized rates of 12.3% and 15.5%. The pattern begged a correction, which actually began during fourth quarter 2014, when both residential and commercial construction fell. The severe weather simply exacerbated that move. But rather than implicitly extrapolate this weakness, as it seems the consensus has done, a wiser conclusion would look to the future as a balance of both the earlier surge and the subsequent retrenchment. While more recent data do exist in this area, an 8.0% jump in April housing starts signals that the correction has largely run its course, but it is not a new surge. &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>Meanwhile, consumer spending, some 70% of the economy, had continued to show good growth. Real consumer spending was the strongest part of the otherwise weak first quarter GDP. It grew at an annualized rate of 3.1%, only slightly slower than the 3.3% rate recorded for the final quarter of 2013. To be sure, some of the recent anxiety about the consumer stems from the weak growth of 0.1% in April retail sales. But before taking that admittedly weak monthly figure too much to heart, it would be prudent to take two additional facts into consideration. First, March retail sales had surged 1.5%. The spring rebound simply occurred early. April was not likely to repeat that performance. On the contrary, a pause was likely. Second, household income through March (the most recent month for which data are available) expanded at a 3.7% annualized real rate, giving households ample ability to sustain spending growth, although it’s not powerful enough to realize the earlier expectations of an acceleration, but certainly enough to avoid more recent fears of a correction.</p>
<p>Finally, there is the disappointing industrial production figure for April, a drop of 0.6%, 7.0% at an annualized rate. This release had shock value, given the consensus expectation of a spring rebound, but that was always an unreasonable expectation. For one, the cold weather of earlier months actually heightened activity in utilities, a major component of the index. Because that part of the index was actually exaggerated by the cold, the more moderate April weather prompted a more precipitous drop than usual in gas and electric usage, a decline of 5.3% in fact. That did much to drag down the overall industrial production figure. This is not likely to repeat in coming months. The other parts of the index, where it was more reasonable to look for a spring surge, might have offset this effect, but they had already enjoyed their rebound in February and March, when mining and manufacturing increased 2.5% a month on average and so were likely to expand at a much more moderate pace by April. Rather than look for a correction going forward, or a surge, a reasonable expectation now would look for an average of these ups and downs of past months, which would produce annualized growth in industrial production of 3.7%, right in line with the slow pace that has typified this recovery.</p>
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Mon, 9 Jun 2014 10:44:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-an-emerging-fear-factor.htmlU.S. Economy: An Emerging "Fear Factor"?<div class="everything">
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<h3><i>Investors appear to be worried that the U.S. economy is increasingly vulnerable to disruptions in emerging economies. They shouldn’t be.</i><b> </b></h3>
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<p>A recent <i>Barron’s</i> article<sup>1</sup> elicited a fearful response from a large number of financial advisors. Quoting a noted New York-based think tank, the piece noted how emerging economies continue to grow as a share of the global economy, verging on 40%. It then went on to argue that their increased importance makes the U.S. economy more vulnerable than it once was to foreign influences and that, if these emerging economies were to collapse or just suffer tough times, this economy would come under considerable strain, forcing the Federal Reserve to hold short-term interest rates lower for longer than many now expect.</p>
<p>It is understandable how such a narrative can generate fear, but on closer inspection, it really says very little about likely future events. It is, of course, irrefutable that the United States is vulnerable to problems in the rest of the world. This country’s economy is big, but still barely 30% of the world’s gross domestic product (GDP), smaller than the European Union (EU), even after all its troubles of recent years, and clearly smaller than the emerging economies as a group. If these or any other significant part of the globe were to suffer a major setback, the U.S. economy would inevitably suffer ill effects, and the Fed would have to trim its monetary policy accordingly. There was only ever a brief period, in the late 1940s and 1950s, when the U.S. economy was such a big part of the world that it seemed almost immune to foreign influences. The question then is not whether the United States would suffer <i>if</i> the emerging economies fell as a group. The answer to that question is clearly, yes. The relevant question is, are these emerging economies <i>likely</i> to suffer in sufficient numbers?</p>
<p>Perhaps the article and the think tank see greater danger because each assumes that emerging economies are more prone to setbacks than developed economies and so their rise acts as a kind of threat that did not previously exist. Though it is hard to see anywhere more vulnerable these days than the EU, emerging economies are indeed known for volatility. It would, however, be a mistake to simply run with such a supposition. For one, emerging economies have become increasingly differentiated over time, moving less and less in tandem with each other than they once did, either in economic or in market terms. If half of them had troubles, and the other half resisted, it would be harder to see a terrible impact on the United States. What is more, their rising size and significance speaks to greater levels of development and presumably relative stability. Indeed, measures of volatility in these economies in the last 40 years have fallen by a fifth.<sup>2</sup> Meanwhile, their rise diversifies the foreign influences on the United States and so could create more stability even if they were not individually more stable, which clearly they are becoming.</p>
<p>Meanwhile, patterns of trade may make the emerging economies less of a threat than they seem or than are other, more developed markets. According to the U.S. Department of Commerce, this country has much less balanced trade with emerging than with developed economies. The data, admittedly, are far from comprehensive, but just using key trading partners, it is apparent that the United States, by a far greater margin than with other trading partners, buys much more from emerging economies than it sells them. Since fluctuations in demand almost always create economic cycles, it would seem then that the rise of emerging economies makes the world more vulnerable to the United States than this country is to the emerging economies. To be sure, secondary and tertiary influences should qualify such a blanket statement, but it does suggest that there is less to fear in this respect from the rise of emerging economies certainly than is suggested in this article.</p>
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<p><span class="legal"><sup>1</sup>Randall Forsyth, “A Scary New World Order,”&nbsp;<i>Barron’s</i>, May 3, 2014.<br>
<sup>2</sup>Data from FactSet.</span></p>
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Mon, 2 Jun 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/what-merger-mania-means-for-the-market.htmlWhat Merger Mania Means for the Market<div class="everything">
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<h3><i>A surge in prospective acquisitions could have positive implications for equities—and the broader economy.</i><b></b></h3>
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<p>A recent piece in this space talked about the movement of money. It investigated recent signs that reserves, long-provided by the Federal Reserve, seemed at last to have begun flowing into the general economy. This discussion takes up money flows of a different kind, those implicit in the recent, dramatic pickup in mergers and acquisitions (M&amp;A). As with those signs that banks are at last beginning to use their excess reserves, this surge suggests that companies finally seem willing to use the cash hoards they have built up and guarded throughout this recovery. At once, these actions show a renewed willingness to take risk, something that should promote more economic growth, and a durable direct support for equities.&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>For quite some time, analysts, including those at Lord Abbett, have looked for a surge in M&amp;A activity. After all, cash at nonfinancial corporations had risen for years. At 15% of total liabilities recently,<sup>1</sup> such relative holdings of cash and cash equivalents would look outsized in any environment but especially one in which they earn so little. But firms remained extremely cautious and added to rather than used their cash hoards. That behavior seems to be changing. So far this year, according to the company Dealogic, U.S.-based companies have agreed to a bit less than $640 billion in mergers and acquisitions. That is the highest amount recorded since 1995, when the firm began compiling such statistics. Deals in the healthcare area have received the greatest attention, but the activity is more widespread. Year to date, M&amp;A activity in telecommunications has topped $80 billion, and in technology, $60 billion. Deals in energy, food, utilities, and finance totaled more than $80 billion. Activity in every major sector, except real estate, picked up markedly from the year-ago period. &nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>For the economy, the crucial encouragement here is the more positive attitude toward risk implicit in such money flows. Until now, the lack of willingness among companies to extend their balance sheets in any way has contributed mightily to this recovery’s disappointing progress. It has held back not just M&amp;A activity but, significantly, also hiring and capital spending. But the new M&amp;A surge offers a welcome sign that perhaps such restrictive attitudes are beginning to change, that down the road managements might also step up their hiring and their capital spending. Also encouraging is how this M&amp;A pickup tells of a more aggressive attitude among lenders. Much of the recent activity has depended on bank financing of a sort that banks have assiduously avoided since 2007. Too much, of course, is dangerous, but the former extreme risk avoidance had also held back the pace of growth.&nbsp; &nbsp;&nbsp;</p>
<p>The M&amp;A activity also brightens the prospects of the equity market. At the very least, it provides direct buying support to pricing. To be sure, many recent deals include stock swaps, but to the extent that they also include a significant proportion of existing cash and borrowed money, they redirect new monies into equities. In addition, these deals speak to still-attractive market valuations. Each time management chooses to acquire rather than build for itself, it announces that equities remain attractively priced, that even after all the stock gains of past years, it is still cheaper to buy than to build. Price movements around these deals speak to both points.&nbsp; According to Dealogic, shares of acquired companies in these recent deals have risen 18% on average the day after the deal is announced, more than historically. What is more remarkable, the shares of the acquirer also have risen, on average, by 4.6%. Historically, the shares of the acquirer have typically fallen on average 1.4% the day after the announcement. That they have risen implicitly reflects the market’s judgment that the acquirer received a good price. &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>
<p>There will no doubt come a time when M&amp;A activity will reflect a dangerous exuberance. That will signal danger for the market and the economy. This recent surge is far from that point. It suggests instead that equity prices have room to rise higher. It also implies that management, now willing to take risk, will help the economy accelerate. Much still suggests continued slow economic growth, as several pieces in this space have argued, and that is still the most likely prospect. But this possibility of a pickup in the pace of economic growth is nonetheless not to be ignored.</p>
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Tue, 27 May 2014 12:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/global-economy-a-chinese-checkup.htmlGlobal Economy: A Chinese Checkup<div class="everything">
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<h3><i>Should investors worry about China’s economic health? Here’s a prognosis.</i><i></i></h3>
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<p>If one were to believe the media, China is on the verge of collapse. But then again, the media has worried over that nation’s collapse since at least 2011; and yet throughout the intervening years, the Chinese economy has managed to keep up its expansion and at a real growth rate north of 7.0% a year. Still, it would be a mistake to dismiss such talk out of hand. China’s growth pace has slowed, the economy clearly needs structural reform, and financial excess has caused much damage. The balance of evidence and probabilities suggests that China will continue to muddle through, as it has, not, however, without rough patches connected to such concerns.&nbsp;</p>
<p><b>A Mixed Economic Picture<br>
</b>Though the news has dwelt on the negative, the economic indicators can best be described as mixed. Real gross domestic product (GDP) grew in the first quarter 7.4% from the same period last year. That is close to the government’s target and actually a touch above consensus. Still, those who lean toward pessimism point out that this growth rate, though many multiples of the pace recorded for the United States, is nonetheless a troubling shortfall compared with China’s 10–12% pace of real growth averaged not too long ago. What is more, some, questioning the reliability of Beijing’s economic statistics, suggest that reality is far less robust than the official figures suggest. Reinforcing such feelings is the HSBC purchasing managers’ survey, which recently recorded a figure of 48.0%, well below the 50% demarcation between growth and decline. Still, against this, factory output has increased 8.8% over the past year, retail sales have grown at double-digit rates, worker incomes are growing faster than previously as is the overall economy, and wages in China’s interior are at last beginning to catch up with coastal and urban wages, though they still have a ways to go.<sup>1</sup>&nbsp; &nbsp;&nbsp;</p>
<p>The weak HSBC figures no doubt trouble Beijing, but otherwise, this mix should be far from upsetting. The Chinese leadership expects slow growth as part of its stated desire to shift the engine of growth from exports toward domestic consumption and development. The authorities had noted, some years ago actually, that China’s economy had risen from a negligible part of global exports in the 1980s to nearly 12% more recently.<sup>2</sup> With the best of will, they acknowledged that that percentage cannot rise indefinitely. This is one reason why they decided to reorient the economy’s focus. In this context, the slowdown may actually come as a welcome sign of success for this long-term plan, as, no doubt, does the news on retail sales, wage growth in general, and relative wage growth in the country’s interior.</p>
<p>Nonetheless, the slowdown still threatens Beijing’s immediate need to produce jobs. Worried, but hardly panicked, Beijing has responded with a two-pronged approach. One part involves a kind of mini-stimulus, including an extension of the tax breaks for small business; additional spending of some 150 billion yuan ($24.6 billion) on infrastructure, mostly on railroads; and an effort to capture flows of foreign capital by allowing cross-border stock purchases with Hong Kong. The other part of the response involves steps to bolster exports by holding down the foreign exchange value of the yuan until the longer-term economic reorientation gains a firmer footing. China also has eased its one-child policy somewhat, but this clearly has a much longer-term objective in mind than any near-term stimulus.<sup>3</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p><b>The Threat from Debt<br>
</b>If the economic picture is, at worst, only mildly troubling, financial matters offer more reason for concern. China has in recent years run up a huge debt overhang, much of it connected to real estate. Private sector financing grew 20% last year, far faster than the economy, much from lending by the shadow banking system. Meanwhile, local governments remain deeply in debt because of failed investments in upscale residential construction and over-ambitious infrastructure development, the by-now famous empty buildings reported breathlessly on <i>60 Minutes </i>and elsewhere. Many of these loans are going bad. When Shanghai Chaori Solar Energy defaulted earlier this year, Premier Li Keqiang warned of other defaults to come. In part, he was acknowledging the existence of the financial overreach, but he also was indicating that, contrary to the past, the government would allow defaults, presumably in order to force a more disciplined approach on lenders.<sup>4</sup></p>
<p>The fear, of course, is that the bad loans will bring down the financial system and so the economy, much as occurred in the West in 2008–09. It is a serious enough concern to have elicited a response from Beijing beyond the embrace of the discipline of default. To exercise control and stem the outsized debt growth, the authorities have all but shut down the shadow banking system. They also have begun to direct lending by the largely state-run banking system. The object is to cut back the flow of credit to extravagant real estate development and the other dubious investment projects typical of the past. There is even talk of bringing in foreign financial firms to discipline lending further in order to avoid such wasteful uses of financial capital, though so far, this is mostly talk. In place of such misdirected uses of funds, there is a push to build needed lower-cost housing, of which, according to government statistics, the country needs more than 75 million units.<sup>5</sup></p>
<p><b>Probabilities<br>
</b>There are risks to be sure. Today’s fears are far from unfounded. But the probabilities suggest that China will contain the financial damage and also, in time, manage the shift from the purely export-led economy to one with a domestic growth engine as well. After all, the track record since such fears have gained currency suggests that the Chinese economy is less fragile than many seem to believe. What is more, Beijing has an urgent need to make it work. The country’s leadership is well aware that economic hardship in China quickly turns to social unrest, even rioting, making failure a much less palatable alternative than it might be elsewhere. For the investor, then, it is reasonable to expect a muddle through, at the very least, during the months and quarters immediately ahead. For the longer term, a successful reorientation of China’s economy in the direction of domestic growth engines promises a raft of new investment opportunities.&nbsp;</p>
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Mon, 19 May 2014 09:35:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/consumers-why-the-united-states-isnt-the-land-of-the-spree.htmlConsumers: Why the United States Isn't the "Land of the Spree"<div class="everything">
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<h3><i>Slow income growth and higher tax burdens for U.S. consumers likely will continue to restrain spending in the largest sector of the economy.</i><b></b></h3>
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<p>The past two discussions in this space argued that the economic recovery, though it will almost certainly continue, will not likely deliver the acceleration of which the media has enthused of late. One examined the employment picture, the other patterns in capital spending. This week’s discussion looks at the consumer sector. At some 70% of the economy, the consumer just about determines the overall pace and direction of any recovery. This analysis, too, confirms that slow growth patterns will likely prevail going forward. &nbsp; &nbsp; &nbsp;</p>
<p>Table 1 lays out the statistical essentials. It shows the major elements of household income, taxes, saving, and spending during the second half of 2013 and so far this year. For perspective, it includes a column (at the far right) showing the proportion of overall personal income reflected in each item on the table.</p>
<p><b>Income &nbsp;&nbsp;<br>
</b>The first block of figures in particular explains why a lasting acceleration is less than likely. Apart from the normal statistical noise, the growth of overall personal income so far this year differs little from the pattern set in the second half of 2013. This aggregate averaged a 3.1% annual rate of expansion during last year’s second half and though it has picked up to a 3.6% rate, so far this year, the difference is hardly significant. Important subcategories show even less difference. Total employee compensation has grown at a 3.0% annualized rate so far this year, slightly less than the 3.1% averaged during 2013’s second half. Wage and salary income, growing at a 3.0% annualized rate so far this year, has actually decelerated from the 3.3% rate of expansion averaged during last year’s second half. Proprietors’ income, too, has decelerated, growing so far this year at an annual rate of 2.4%, slightly below the 2.6% rate of advance averaged during the last six months of 2013. Income from assets (dividends, interest, and net capital gains) actually suggests a loss of growth momentum altogether.<sup>1</sup></p>
<p><b>Tax Effects &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;<br>
</b>Nor does the influence from Washington suggest an acceleration. Tax burdens so far this year have grown at a 2.4% annualized rate, faster than the 1.3% annual rate registered during last year’s second half. To be sure, this comparison may be misleading. The tax picture last year was remarkably uneven because so many managements, worried about tax hikes in 2013, paid huge bonuses and special dividends during 2012’s fourth quarter, and this caused a surge in tax payments during the spring tax season in 2013, when flows of tax money actually expanded at more than a 10% annual rate. Little wonder, then, that in the summer quarter, after this effect had run its course, the flow of tax payments dropped. For all these gyrations, however, aftertax income, what the Commerce Department calls “disposable income,” has averaged fairly steady but slow growth, expanding at a 3.4% annualized rate during last year’s second half and 3.6% so far this year.&nbsp;</p>
<p>This picture says fairly definitively that matters going forward should remain pretty much as sluggish as they have throughout this recovery. Certainly, the pattern of hiring, discussed here two weeks ago, confirms that there is little likelihood of a surge in income that might alter established, slow-growth income patterns. To be sure, Washington this year will offer less of a drag on the growth of aftertax income than it did in 2013. For the whole of last year, increased tax rates, plus the effect of the sudden spring gain, pushed up tax burdens by more than 8%. The additional take from the consumer’s pocket amounted to $101.4 billion more than if taxes had just tracked income. It was, incidentally, more than the whole spending sequester over which so much ink was spilled and Washington expressed so much anxiety. With no new taxes or special payouts this year, the consumer at least will avoid a shock.</p>
<p><b>Savings<br>
</b>Even this, however, is unlikely to produce the acceleration of which so many are talking. As is only partially evident in Table 1, consumers shouldered last year’s additional tax burden by reducing their flows into savings. These fell at more than a 5% annual rate on average during last year’s second half. Though taxes have stabilized, albeit at higher rates, consumers seem disinclined to spend and more inclined to reestablish their savings flows. So far this year, as the table shows, their savings flows have jumped at a 33.2% annual rate. This may not last. They may turn to spending, but so far, the picture suggests that even this relief offers little reason to look for the talked-about acceleration in consumer spending or the economy in general. &nbsp;</p>
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<p><b><span class="rte_txt_green">Table 1. Consumer Sector Statistical Essentials</span><br>
</b><i>Consecutive growth, seasonally adjusted, annualized</i></p>
<table class=no_style border="0" cellspacing="0" cellpadding="0">
<tbody><tr><td width="235" valign="top"><p><b>&nbsp;</b></p>
</td>
<td width="78" valign="top"><b><br>
3Q</b></td>
<td width="90" valign="top"><b><br>
4Q</b></td>
<td width="107" valign="top"><b><br>
2014 YTD</b></td>
<td width="128" valign="top"><b>Pct. of Total <br>
Year-end 2013</b></td>
</tr><tr><td width="235" valign="top"><p>Personal Income</p>
</td>
<td width="78" valign="top"><p>4.0%</p>
</td>
<td width="90" valign="top"><p>2.2%</p>
</td>
<td width="107" valign="top"><p>3.6%</p>
</td>
<td width="128" valign="top"><p>100.0%</p>
</td>
</tr><tr><td width="235" valign="top"><p>Compensation of<br>
Employees</p>
</td>
<td width="78" valign="top"><p>2.4</p>
</td>
<td width="90" valign="top"><p>3.7</p>
</td>
<td width="107" valign="top"><p>3.0</p>
</td>
<td width="128" valign="top"><p>62.7</p>
</td>
</tr><tr><td width="235" valign="top"><p>Wages and Salaries</p>
</td>
<td width="78" valign="top"><p>2.6</p>
</td>
<td width="90" valign="top"><p>3.9</p>
</td>
<td width="107" valign="top"><p>3.0</p>
</td>
<td width="128" valign="top"><p>50.6</p>
</td>
</tr><tr><td width="235" valign="top"><p>Proprietor’s Income</p>
</td>
<td width="78" valign="top"><p>5.9</p>
</td>
<td width="90" valign="top"><p>-0.7</p>
</td>
<td width="107" valign="top"><p>2.4</p>
</td>
<td width="128" valign="top"><p>9.5</p>
</td>
</tr><tr><td width="235" valign="top"><p>Income on Assets</p>
</td>
<td width="78" valign="top"><p>7.6</p>
</td>
<td width="90" valign="top"><p>-0.1</p>
</td>
<td width="107" valign="top"><p>-3.0</p>
</td>
<td width="128" valign="top"><p>14.2</p>
</td>
</tr><tr><td width="235" valign="top"><p>Tax liability</p>
</td>
<td width="78" valign="top"><p>-2.7</p>
</td>
<td width="90" valign="top"><p>5.3</p>
</td>
<td width="107" valign="top"><p>2.4</p>
</td>
<td width="128" valign="top"><p>11.8</p>
</td>
</tr><tr><td width="235" valign="top"><p>Disposable Personal<br>
Income</p>
</td>
<td width="78" valign="top"><p>4.9</p>
</td>
<td width="90" valign="top"><p>1.8</p>
</td>
<td width="107" valign="top"><p>3.6</p>
</td>
<td width="128" valign="top"><p>88.2</p>
</td>
</tr><tr><td width="235" valign="top"><p>Personal Outlays</p>
</td>
<td width="78" valign="top"><p>3.9</p>
</td>
<td width="90" valign="top"><p>4.3</p>
</td>
<td width="107" valign="top"><p>3.0</p>
</td>
<td width="128" valign="top"><p>84.6</p>
</td>
</tr><tr><td width="235" valign="top"><p>Savings Flows</p>
</td>
<td width="78" valign="top"><p>28.0</p>
</td>
<td width="90" valign="top"><p>-38.2</p>
</td>
<td width="107" valign="top"><p>33.2</p>
</td>
<td width="128" valign="top"><p>3.6</p>
</td>
</tr></tbody></table>
<p><span class="legal">Source: Department of Commerce.</span><br>
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Mon, 12 May 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/capital-spending-why-caution-still-rules.htmlCapital Spending: Why Caution Still Rules<div class="everything">
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<p>Corporate spending behavior provides a key sign as to why this recovery will almost surely remain slow. Companies large and small show a distinct lack of expansionary enthusiasm. The last commentary in this spot examined the slow pace of hiring. This one looks at the reluctance of firms to spend for capital investments. They are spending some, of course. But mostly they continue to harbor huge cash balances and hold back, at all levels of such spending, on new equipment, software, and premises. Nor do orders patterns offer any reason to expect an acceleration anytime soon. &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Corporate Finance<br>
</b>Corporate balance sheets provide some of the most compelling evidence in this picture. According to the Federal Reserve, nonfinancial corporations hold almost $1.7 trillion in cash and cash equivalents, a huge sum even by today’s standards. It amounts to more than 11% of their total liabilities, a remarkably high number that is much more impressive given that these monies earn next to nothing and actually lose purchasing power after inflation. It speaks even louder to corporate caution that rather than spend this cash, companies actually have expanded such balances over the past year, in absolute and relative terms, growing them by 13.5%, far faster than the 7.8% growth in total nonfinancial corporate assets.</p>
<p><b>Actual Spending &nbsp; &nbsp;<br>
</b>The same sort of picture emerges from statistics on actual real capital spending. Last year, spending by all American business on new equipment increased at a real rate of only 3.9%, faster than the overall economy, but hardly indicative of a major corporate bet on the future. Real spending on premises actually fell by 2.7%. Outlays on software, what the Bureau of Economic Analysis calls “intellectual property products,” is the strongest major category, but even it has grown only at a 6.9% annual rate in real terms. More telling, perhaps, is that it is the only major category to accelerate from 2012, when it advanced only 2.9% in real terms. For the other aspects of capital spending, 2013 actually decelerated from 2012. The growth in real spending on equipment last year was 0.6 percentage points slower than the 4.5% recorded in 2012, while last year’s decline in real spending on premises was a major shift from 2012’s 9.2% growth.<sup>1</sup>&nbsp;</p>
<p><b>Orders and Prospects<br>
</b>Orders numbers suggest that things will stay lackluster going forward. Though highly volatile from one month to the next, trends in orders for capital goods are otherwise an excellent indicator of corporate intensions. And over the last four months, these figures have declined on balance at a 3.8% annual rate. Removing the especially volatile defense sector makes the message even more grim. In that case, orders registered an annualized decline of 20.3% during this time. To be sure, March was up strongly, but it should be given earlier losses, and it is the cumulative effect that counts. The volatility recommends against any extrapolation of these moves, positive or negative, but at the same time the picture here—in actual spending, corporate finances, and orders—argues forcefully against any expectation of an acceleration in capital spending anytime soon, much less something sufficient to drive an acceleration in the overall economy.<br>
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Mon, 5 May 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/a-slow-motion-us-jobs-recovery.htmlA Slow-Motion U.S. Jobs Recovery<div class="everything">
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<p>While the jobs market stumbles along, as it has for some time, there is much talk about change. The Congressional Budget Office (CBO) worries about the ill effects of the Affordable Care Act (ACA). The White House, not surprisingly, takes a more upbeat view. Some commentators, seemingly simply bored of well-established slow-growth patterns, talk about a pickup, perhaps only for something new to say. But the fact is that little has changed. The same forces that have kept jobs growth slow remain in place and likely will continue in place for the foreseeable future. The statistics released regularly by the Labor Department confirm the fact. &nbsp;&nbsp;</p>
<p><b>The Statistical Landscape<br>
</b>Right up through the latest releases, the data tell a consistent story, one of progress, but at a depressingly slow pace. In the latest figures for March, for instance, payrolls grew by 192,000. That was a welcome improvement over the weather-depressed monthly hiring rate of 114,000 recorded for December and January.<sup>1</sup>&nbsp;But considering that the earlier, extremely slow rate called for a bounce as the weather improved in March, the figure was actually disappointing, slower, in fact, than the 203,000 a month averaged in 2013. Had it not been for that weather-based bounce, the March report would have been still less encouraging. It is noteworthy in this regard that manufacturing actually shed 1,000 jobs during that month, and almost half the jobs gains occurred in only four sectors: construction, transport and warehousing, retail trade, and health services. All but the last are extremely weather sensitive. It also is noteworthy that an additional one-fifth of the jobs growth recorded for March occurred in temporary employment—hardly a sign of a turn to robust hiring. &nbsp;&nbsp;</p>
<p>There is no implication here of another decline. That is not at all likely. Rather, the point is to question recent talk of acceleration. Each month, of course, will continue to have its own ups and downs. Behind such statistical noise, however, nothing different is happening than has prevailed throughout this recovery. In 2013, for instance, the best month for new job creation, February, showed 280,000 net new hiring; the worst, December, saw only 84,000. In 2012, the best month, January, saw net hiring of 360,000, while the worst, June, saw only 88,000. In 2011, the best month, April, saw net hiring of 322,000, while the worst, January, saw only 70,000. This year has run true to this form.&nbsp; Some optimists have pointed to declines in weekly claims for unemployment insurance. But these only reflect those let go from their job. It is only reasonable that firing would slow in the fifth year of recovery. Relief on this front does not necessarily mean firms have become more enthusiastic about new hiring, as the above comparison shows.</p>
<p><b>The Whys<br>
</b>This recovery’s pattern is distinctly different from past benchmarks. On average, during the four previous recoveries—in the early 2000s, in the mid-1990s, in the mid-1980s, and in the mid-1970s—payrolls grew an average of 250,000 a month. This recovery so far has averaged a monthly gain of 137,000. Economic historians will surely devote much time to explaining this recovery’s atypically sluggish nature. No doubt the aging of the American workforce has something to do with it. But until detailed analysis uncovers all the influences, two factors present themselves as reasons: 1) the lingering legacy of the great recession of 2008–09 and 2) the uncertainties brought by the ambitious legislation produced in Washington in 2009 and 2010.</p>
<p>Much commentary has dwelt on the effect of legislation, but it would be a mistake to underestimate the recession’s continuing impact. Especially because the downturn had its roots in a financial collapse, it has left lasting scars on many managements and colored their decision making accordingly. The signs are evident in the huge cash reserves companies continue to carry, much larger, absolutely and relatively, than in past recoveries.&nbsp; Even now, five years after the upturn began, nonfinancial firms hold cash and cash equivalents on their balance sheets equal to a whopping 11.3% of total liabilities. No doubt this preference for cash stems in no small part to the failure of banks during the financial crisis to honor previously arranged lines of credit. But whatever its specific cause, it speaks to a continuing caution that has held back capital spending, certainly compared with past recoveries, and even the mergers and acquisitions that would normally occur with so much available cash, though these just recently have begun to accelerate. This abiding reluctance to spend for expansion and expend these reserves has surely held back hiring.</p>
<p>The Dodd-Frank financial reform legislation has compounded these effects. Setting aside whether this legislation is good or bad, effective or not, it is comprehensive enough to sow much doubt about the nature of future financial arrangements, the availability of credit going forward, possible covenants-attached loans, the nature of the credit available to firms, and the cost of that credit, both the rate and any fees that may arise. Though the law passed some years ago, little clarity has emerged, for the legislation left much implementation at the discretion of regulators who have hardly made their positions definite. Indeed, they have yet to write many of the rules required of them by the law. The “Volcker rule,” for example, to prevent banks from proprietary trading, took two years to evolve and still remains ambiguous.</p>
<p>The ACA has had its retarding effects on jobs growth from both the demand and the supply side. Again, setting aside whether the legislation is good or bad, effective or not, its breadth could not help but affect hiring decisions. Managements in small, medium, and large firms have commented for years now that they cannot calculate the cost of a new employee. It is not, they insist, that the legislation would raise the cost of hiring.&nbsp; Rather, it is that the ambiguity leaves them in doubt where to bring the size of their workforce. They have, accordingly, postponed hiring decisions. Many had hoped, as 2014 approached, that the law’s implementation would bring clarity. But so much has been postponed and modified, uncertainties have remained.&nbsp;</p>
<p>Meanwhile, recent CBO work suggests that on the supply side of the labor market the law has discouraged job seekers. The problem, according to these non-partisan analysts, is the government insurance subsidy for low-income people. Because that subsidy goes away as incomes rise, it acts like a tax on additional earned income, up to 85% in some cases, according to the CBO analysis. Many, the CBO concludes, will, as a consequence, decide against work.</p>
<p><b>And Looking Forward<br>
</b>Some of this burden surely will lift over time. The worst memories of the great recession will fade and with them the fears they have engendered. The provisions of Dodd-Frank and the ACA will become clearer, allowing managements to make definite calculations about the cost of hiring, borrowing, and expansion generally. Any ill effects of the ACA on labor supply will stabilize, too. If, as now seems likely, they enlarge the ranks of the permanently unemployed and underemployed, wages will adjust so that job seeking should resume for others. But as the patterns of the last few years make clear, this relief will likely arrive only very gradually. The rollout of the ACA certainly makes clear that ambiguity will hang over this important law for a long time to come. For the jobs market, then, progress will continue, as it has to date, but at the plodding pace to which all have grown accustomed. &nbsp; &nbsp;<br>
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Mon, 28 Apr 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/will-baby-boomers-bust-the-markets.htmlWill Baby Boomers Bust the Markets?<div class="everything">
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<h3>Worries that large-scale liquidation of investments by retiring baby boomers will pressure financial markets are overstated. Here’s why.</h3>
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<p>The usual suspects have issued a dire warning: the baby-boom generation is retiring; markets are vulnerable. It sounds plausible. Financial advisors can see their older clients liquidating investments to support their retirement needs. The expectation of such events on a larger scale leads many to feel this fear. But if this story, like so many other scare stories, harbors a kernel of truth, this heavily publicized worry is vastly overstated. &nbsp;</p>
<p><b>The Basis for Fear<br>
</b>The broad demographic picture certainly is capable of raising anxiety. According to the Bureau of the Census, low birth rates will continue to slow the flow of young people into the workforce, while increasing longevity will enlarge the proportion of dependent retirees. The number of working-age people will fall, from an already low 5.2 for each retiree today to barely 3.3 by 2030.<sup>1</sup>&nbsp;Since retirees tend to draw on pensions and their own savings to support themselves after they have left off active production, these demographic patterns naturally raise fears of net liquidations in financial markets and so, consequently, downward price pressure, especially since the relative shortfall of the working-age in the population means that the nation will also have proportionally fewer people saving, contributing to pension plans, and generally replenishing the pool of investable assets. But while this demographic picture leaves reason for many longer-term economic and financial concerns and will force many changes in this economy and its markets, at least four points raise doubts about these particular, immediate, market concerns.&nbsp;</p>
<p><b>No Reason for Panic about the Pace of the Drawdown<br>
</b>First, the changing demographics will alter retirees’ investment strategies. Decades ago, people had to support five, maybe 10 years of retirement. All but the wealthiest converted assets, largely to bonds, as the retirement date approached and then drew down a significant part of that asset base each year. But today, when people can contemplate 20 or more years of retirement, such past practices no longer seem so wise. Retirees will draw down on their asset base much more slowly than their fathers and mothers did in retirement. The newer retirees will strive to protect the principal of their investment base much more carefully. Indeed, their planning horizon is so long that they will tend to keep much more of their portfolio in equities for longer than once was the case.</p>
<p>Second, the changing nature of the investment industry further suggests that funds will move much less dramatically than is generally expected. As financial advisors shift increasingly toward a fee-based instead of a transaction-based business model, they will become less eager certainly than they once were to move assets about. Registered investment advisors, already 25% of the nation’s wealth-management business and growing fast, are almost all fee-based. Even the wire houses, once the center of transaction-based brokerage, are moving toward the fee-based model. Morgan Stanley Wealth Management, the nation’s largest, reports 37% of its assets are fee-based. Bank of America’s Merrill Lynch reports 44% and Wells-Fargo 27%. The proportions are growing, too, even as the overall dollar amounts rise.&nbsp;</p>
<p>Third, pension funds are less likely to liquidate, too. Indeed, they face legal restraints that should prevent much of a drawdown in assets. All pension funds (Social Security excepted), even those run by state and local governments, must by regulation maintain an acceptable level of funding. If contributions from the existing workforce cannot support that level, then the sponsor of the fund must direct other revenues toward it. Corporations will have to channel revenues toward pension investments, and public authorities will have to direct tax monies to their funds, effectively putting funds into financial markets to supplement any shortfall.<sup>2</sup>&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;&nbsp;</p>
<p><b>Still Less Reason to Panic Now<br>
</b>Fourth, any impact will face delay. Although the long post–World War II baby boom is indeed beginning to retire, the biggest birth years of that boom came toward its end, between 1958 and 1961. The birth rate figures of the time tell the story. At the beginning of the baby boom in the late 1940s, the birth rate was just over three children in the average woman’s lifetime. That figure rose throughout much of the 1950s, and by 1957 it had reached 3.7, a gain of about 20%. The rate stayed at that high level until 1961, when it began its long decline. As a consequence, the bulk of the baby boom is not retiring now or anytime soon. Rather, it has enlarged the part of the population in its fifties, an age well recognized as the highest earning and highest saving period in a person’s lifetime. Even as the beginning of the baby boom is retiring, then, the bulk of it is earning, saving, building up pension assets, and more than offsetting any drawdown from the older, smaller, retiring part. These people will not reach normal retirement age until 2022–23, and they will not likely begin their drawdown until later, suggesting that any real problems are eight to 10 years off, at least—time enough for advisors to shift portfolio strategy, if necessary, and time enough for many other things to change.<sup>3</sup>&nbsp;&nbsp;</p>
<p><b>A Last Word<br>
</b>This less frightening picture does not ignore the ill effects of the demographic trends. It recognizes the very real and detrimental financial and economic impact from the growing mismatch between dependent retirees on the one hand and taxpaying, saving, pension-contributing producers on the other. This fact of life in the United States will weigh heavily in coming years and force dramatic change in business practice, production emphasis, and public policy, as an earlier series in this space described. But the panic over the immediate market impact is misplaced and sadly typical of those who prefer drama to probability.<br>
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<p><span class="legal"><sup>1 </sup>Milton Ezrati, <i>Thirty Tomorrows </i>(Thomas Dunne Books/St. Martin’s Press, 2014).<br>
<sup>2</sup> Joshua Brown, “The Quiet Takeover that Keeps Stocks Moving Up No Matter What,” <i>Business Insider, </i>March 5, 2014.<br>
<sup>3</sup> Data from the Department of Commerce.</span></p>
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Mon, 21 Apr 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/quarterly-roundtable-economic-engines-in-need-of-overhaul.htmlQuarterly Roundtable April 2014<div class="everything">
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<h3>Reforms underway in Europe, China, and, perhaps, Japan will be critical for the global economy.<span style="font-size: 12px;"></span></h3>
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<p style="font-size: 12px;"><b>In Brief</b></p>
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<li><p>The U.S. economy is likely to continue to muddle along. The housing recovery, although not over, probably won’t contribute much to economic growth in 2014.</p>
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<li><p>Concerns that the U.S. stock market is in a bubble are overwrought. The price-to-earnings (P/E) ratio on the S&amp;P 500<sup>®</sup> Index is not much higher than the long-term average, and earnings are probably sustainable. Earnings are higher than normal because of operating leverage.</p>
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<li><p>Banks in the eurozone, which have been slow to repair their balance sheets in the wake of the financial crisis, are undergoing a thorough review of their assets in preparation for stress testing later in the year. The bad debts are well-known, so although some banks are likely to fail, the risks are manageable.</p>
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<li><p>Excessive borrowing in some emerging markets has come to light since the Federal Reserve began tapering the bond-buying program known as quantitative easing. Currency depreciation in some countries is making the repayment of dollar-denominated debt more difficult. But not all emerging markets are being hurt, and the market is differentiating among them.</p>
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<li><p>Japan’s ability to handle its considerable debt burden will depend on the success of structural reforms designed to stimulate economic growth. The country’s interest expense could soar because Japan can no longer depend on high domestic savings to absorb government debt issuance. Rates may have to rise to attract outside investors.</p>
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<p style="font-size: 12px;">Nearly four years after the financial crisis triggered by the downgrading of Greek government debt, the eurozone is getting serious about bank reform. The European Central Bank (ECB) will spend the next several months assessing the quality of the assets in eurozone banks in preparation for stress tests to be conducted late in 2014. Financial institutions all across the eurozone will be held to a uniform standard and, if necessary, will have to raise additional capital. If all goes well, Europe’s banks will be rejuvenated and able to get back to the business of lending, which is needed desperately.</p>
<p style="font-size: 12px;">Revitalization is needed in Japan as well, and it hinges on the “third arrow” of Prime Minister Shinzo Abe’s economic program, including broad structural reforms. Along with monetary and fiscal stimulus, these as yet unnamed reforms are intended to spur the growth that will enable Japan to keep from collapsing under its massive load of government debt.</p>
<p style="font-size: 12px;">Economic lethargy is not a problem in China, but reforms are occurring there as well, as errant corporate behavior is increasingly allowed to be disciplined by the market. But moves to shut down shadow banking and deregulate the banks may be worrisome. Elsewhere in emerging markets, excessive borrowing is now being exposed by currency devaluations resulting from tapering of the Federal Reserve’s quantitative easing program.&nbsp; Many corporate borrowers are struggling to pay the cheap dollar-denominated debt they accumulated during the Fed’s accommodative policy of the past several years. But not all emerging markets have borrowed too much, and the markets are winnowing out the imprudent.</p>
<p style="font-size: 12px;">Despite the absence of reforms in the United States, the economy continues to muddle along. A surge in acquisitions points to some optimism and the likelihood that the stock market is not overvalued.</p>
<p style="font-size: 12px;">Addressing these and other topics are <b><a href="/content/lordabbett/en/global/biographies/milton-ezrati.html" target="_blank">Milton Ezrati</a>,</b> <b>Partner,</b> <b>Senior Economist and Market Strategist</b>; <b><a href="/content/lordabbett/en/global/biographies/zane-brown.html" target="_blank">Zane Brown</a>, Partner and Fixed Income Strategist</b>; <b><a href="/content/lordabbett/en/global/biographies/harold-sharon.html" target="_blank">Harold Sharon</a>, Partner and International Strategist</b>; and <b><a href="/content/lordabbett/en/global/biographies/david-linsen.html" target="_blank">David Linsen</a>, Director of Domestic Equity Research</b>.</p>
<p style="font-size: 12px;"><b>Q:&nbsp; The economy continues to plod along. Is there anything to suggest that it will break out of this pattern anytime soon?</b></p>
<p style="font-size: 12px;"><b>Zane Brown:</b>&nbsp;It’s difficult to tell how much of the slowdown is due to weather. In December, many investors had expectations for economic growth of 3–3.5% this year, but it looks like it will be closer to 2.5%. The severe winter weather has made it difficult to know for sure how the economy is really doing, and we won’t know until the end of April, when first quarter GDP figures come in.</p>
<p style="font-size: 12px;"><b>Milton Ezrati: </b>&nbsp;Economic growth is likely to continue at a slow rate. Consumers have repaired their finances, so there is no reason to retrench, but the fear that has persisted since the recession is going to keep consumer spending moderate. And since consumer spending is about 70% of the economy, that means growth is likely to continue, but at a slow rate. But it also means that this growth is durable.</p>
<p style="font-size: 12px;"><b>Harold Sharon:</b>&nbsp;This doesn’t respond directly to the question, but I think it’s fascinating that after years of sitting on piles of cash, companies are now gobbling up their neighbors. It is interesting that these acquisitions are not just in one industry. They’re not all technology; they’re also occurring in retail, healthcare, media, and chemicals, for example.</p>
<p style="font-size: 12px;"><b>David Linsen:</b>&nbsp;But that does suggest that companies have confidence in the outlook for the economy. They wouldn’t spend billions of dollars if they thought the economy was about to roll over. So I think it’s a signal of corporate confidence. The past several years the market has rewarded dividends and share buybacks; today, the market is also rewarding companies that smartly allocate M&amp;A [mergers &amp; acquisitions] and growth capital.</p>
<p style="font-size: 12px;"><b>Q:&nbsp; Has the housing recovery peaked, and is it running out of steam? &nbsp;</b></p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;Housing was a slight drag on the economy in the second half of 2013. But the pace of growth in the first half was unsustainable. It was all concentrated in regions, such as Florida, that had suffered the most.&nbsp;</p>
<p style="font-size: 12px;">When prices and sales volumes are well below their peak, then the slightest growth can make an enormous percentage difference, and that’s what happened in the first half of 2013. In the second half, the market adjusted to that demand, and mortgage rates rose.&nbsp;</p>
<p style="font-size: 12px;">But three facts -- that those rates rose by about 100 basis points, that the housing sales and construction were essentially flat, and that prices still continued to rise -- suggests the market has not peaked.<sup>1</sup></p>
<p style="font-size: 12px;"><b>Linsen:</b>&nbsp;Since the credit crisis, there have been five or six years of household formation without much new housing supply added. Job creation is occurring, though not at high levels, mortgage rates are still low by historical standards, and consumers are becoming more confident about their jobs and their ability to purchase a home. These factors suggest an upward bias in the housing market is likely for the next several years.</p>
<p style="font-size: 12px;">Last year, housing starts amounted to just under one million units.<sup>2</sup> Our housing analyst has projected 10% growth in housing starts this year, and he expects starts to get back to normal, at around 1.4 million a year, in 2016 or 2017. So that’s about an additional 100,000 starts per year over the next four years.</p>
<p style="font-size: 12px;"><b>Brown:</b>&nbsp;That’s a little brighter than I would have expected. So, in other words, you’re saying the market hasn’t peaked. But because of the surge this year, I don’t think housing is likely to add meaningfully to economic growth next year as one would expect in a normal recovery. &nbsp;&nbsp;</p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;I’ll add to David’s comments by saying housing affordability—even with the rise in mortgage rates and the rise in prices—remains very good by historical standards.</p>
<p style="font-size: 12px;"><b>Q:&nbsp; Some observers believe the U.S. stock market is in a bubble. They argue that valuations are too elevated, especially given that corporate earnings are very high and, arguably, unsustainable. Is the market indeed in a bubble?</b></p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;The M&amp;A boom that Harold mentioned also speaks to that. If it’s cheaper to buy a company than it is to invest in your own growth, then there is no bubble. If corporate America thought the market was overpriced, we would be seeing a lot of IPOs [initial public offerings]. IPOs are up, but they’re certainly not at record levels.</p>
<p style="font-size: 12px;"><b>Linsen:</b>&nbsp;That M&amp;A strategy is being reinforced by the market. The acquirer’s stock is going up in many of these deals because there is so much accretion to earnings. So, I think M&amp;As will be a major theme this year because the market is sending the signal that this is a good allocation of cheap capital.</p>
<p style="font-size: 12px;"><b>Sharon:</b>&nbsp;So corporate America is saying that the stock market bears have got it wrong because we can buy these businesses, clients, assets, etc., for an unbelievably good price.</p>
<p style="font-size: 12px;"><b>Ezrati:</b> As for corporate earnings, they’re more sustainable than people think. They have risen much more than have corporate revenues, but that isn’t unusual. Historically, the earnings of companies in the S&amp;P 500<sup>®</sup> Index have been much more volatile than the revenues.</p>
<p style="font-size: 12px;">U.S. corporations are very capital intensive, and while that enables companies to do more with fewer employees, it also raises their fixed costs relative to their total costs. These fixed costs don’t go away during an economic downturn the way employee costs do. You can’t lay off equipment. Fixed costs must be covered even when revenues decline, so much of that shortfall comes right out of the bottom line. But when revenues rise, much of the increase goes right to the bottom line, once the fixed costs are covered. For that reason, when you look at a chart of historical changes in revenues and earnings, you see that the earnings are much more volatile than the revenues.</p>
<p style="font-size: 12px;">As for valuation multiples, historical data show that they are cyclical, and when they are advancing from lows, they will often rise well past the long-term average. The trailing P/E on the S&amp;P 500 is 17.2 [as of March 20, 2014], not that much higher than the long-term average of about 16.5. So, it could show further gains.<sup>3</sup></p>
<p style="font-size: 12px;"><b>Brown:</b>&nbsp;This also raises the question of whether certain other markets, such as high-yield bonds and bank loans, are in a bubble. High yield certainly doesn’t appear to be. Debt ratios are very low, and interest coverage ratios are very high. Earnings continue to improve, and the cost of debt continues to go down.</p>
<p style="font-size: 12px;">When a turn in the credit cycle occurs, it’s normally accompanied by aggressive borrowing, combined with aggressive interest rate increases by the Fed in an attempt to slow an overheating economy. In the current cycle, we don’t see any of these signs.</p>
<p style="font-size: 12px;">One development that many skeptics cite is the decline in covenant protection. Covenant-lite loans have increased, but that isn’t necessarily a sign of lateness in the credit cycle. I think it’s a sign that interest rates are so low that some investors are willing to give up certain protections in exchange for a higher yield.</p>
<p style="font-size: 12px;">In the last cycle, around 2007, covenant-lite loans increased and were associated with subsequent credit problems. Those credit problems may have been more related to aggressive borrowing particularly to finance leveraged buy outs. In the current cycle, most of the issuance is refinancing that replaces higher coupon debt with lower-cost financing. That means the new borrowing is helping to strengthen companies, not weaken them.</p>
<p style="font-size: 12px;"><b>Q:&nbsp; The European Central Bank (ECB) is undertaking a comprehensive review of the eurozone’s banks, which are heavily leveraged and have not made much progress in cleaning up their balance sheets since the credit crisis. How fragile is Europe’s banking system and how much of a threat is it to financial stability? &nbsp;</b></p>
<p style="font-size: 12px;"><b>Sharon:</b>&nbsp;I think it’s fairly well known where the bad debt has come from. It tends to be from the slow-growth periphery countries of Greece, Spain, and Italy. It’s also well known that loans to the shipping industry are a problem for a lot of German banks. So I don’t think European banks are a huge threat to the financial system as a whole. But I agree that there are still some troubled institutions in need of raising capital.</p>
<p style="font-size: 12px;">Historically, each country regulated its own banking system. This allowed for political interference, nationalistic policies to protect banks, and regulators willing to provide many levels of forbearance over the last five years.&nbsp; As a result, some banking markets in Europe have been slow in recognizing the full extent of their bad debts and in bolstering their capital base.</p>
<p style="font-size: 12px;">But as of this year, the ECB has become the single banking regulator for the entire eurozone. So between now and July 2014, it will conduct an “asset quality review.” That means that one uniform standard for all regulatory definitions and rules will be applied to all banks. So, the value of assets and collateral, for example, will be determined in one uniform way. That alone is uncovering some problems.</p>
<p style="font-size: 12px;">One Italian bank, for example, was recently forced to write down massive amounts of goodwill related to banks it acquired 15 years ago. Another Italian bank had to raise capital equal to 100% of its market capitalization. All of this was pretty well known, though the size of the bad debts in some cases was not. But these troubled banks are coming to grips with the new standard as the ECB asserts itself.&nbsp;</p>
<p style="font-size: 12px;">The good news is that the problems are coming to light and that politics will play less of a role in bank regulation. Because it’s the ECB that is conducting these reviews and stress tests, the process will be less subject to political influence.</p>
<p style="font-size: 12px;">This is the first time these measures will be conducted by independent, prudential banking authorities, not national banking authorities. So, this is the beginning of the eurozone-wide bank supervisory system. Will a few banks go under? Yes, but they’ll probably be absorbed by larger banks or be wound down with minor systemic consequences.&nbsp;</p>
<p style="font-size: 12px;">After the asset quality review, banks will have to do whatever is necessary to meet the new capital requirements. But the most important change that has happened recently is that the capital markets are open for these institutions. As an example, one of the worst banks in Spain did a share placement recently. A year ago that would have been unheard of. We've seen capital raised in all the troubled European banking markets recently.&nbsp;</p>
<p style="font-size: 12px;"><b>Brown:</b>&nbsp;The outcomes of this process may also be worsened by geopolitical risk. With Ukraine, Syria, and other hot spots, there could be even more bad debt on the books of some banks than was expected. Bad debts could be further aggravated if Russia responds to sanction by declaring a moratorium on debt payments by state-related Russian companies.</p>
<p style="font-size: 12px;"><b>Q: Emerging markets have been under some pressure since the Fed first mentioned in May 2013 that it would soon begin to taper the bond-buying program known as quantitative easing. How much of a threat is tapering to emerging markets?</b></p>
<p style="font-size: 12px;"><b>Sharon:</b>&nbsp;Emerging markets are a very diversified group of countries, and the market has been smart enough to differentiate among them. As a result of the Fed’s extraordinarily accommodative policy, some emerging market economies were able to borrow at single-digit rates for the first time, and some borrowed too much.&nbsp;</p>
<p style="font-size: 12px;">On the other hand, borrowers in some emerging markets learned from the Asian crisis in the 1990s. Asian banks, for example, refrained from excessive borrowing this time around because they now understand the risks a little better, and as a result, they have not fallen into the same kind of trouble that borrowers in certain other emerging markets have. When the Fed actually began to taper, it was the countries with large current account deficits—especially Turkey, South Africa, Indonesia, Brazil, and India—that were hurt and saw large portfolio flows out.&nbsp;</p>
<p style="font-size: 12px;">The potential problem this time is largely with corporate debt. According to the Bank for International Settlements, in the three and half years from January 2010 through June 2013, $990 billion in international bonds were issued by emerging markets, and of that amount, $700 billion was issued by non-bank corporate entities. There are large amounts of corporate debt coming due in 2014 in places such as Indonesia, Brazil, and South Africa. We've seen one large Brazilian bankruptcy, for example, so these upcoming corporate redemptions are worth following closely. &nbsp;</p>
<p style="font-size: 12px;"><b>Brown:</b> The problem is that in many cases they’ve already accessed the capital markets. In some instances, they have borrowed a lot, expecting that the robust growth rate of three years ago would continue. They have borrowed in dollars, but their revenues are in the local currency. In many cases, these local currencies are now worth less, but the dollar-denominated debt must still be paid. So, some companies are in a difficult position, and, therefore, may not be able to refinance in the capital markets. &nbsp;</p>
<p style="font-size: 12px;"><b>Sharon:</b>&nbsp;Places such as the Philippines, Mexico, and Colombia are doing better than many other emerging markets. The Central European countries were doing better until recently, and, of course, there is the Ukraine, which has more than $135 billion in external debt.<sup>4</sup>&nbsp;That’s a relatively small amount, but it’s big enough that it could lead to contagion.</p>
<p style="font-size: 12px;">In Asia, China’s economy is slowing, but growth is still occurring. There’s been a large default recently, and the system hasn’t fallen apart. That has shown that a private default can be done in China. So, not all the signs coming from emerging markets are negative.</p>
<p style="font-size: 12px;"><b>Brown:</b> China’s debt problems have scared investors, but I’m more concerned about the moves to shut down the shadow banking system [which provides financing to small companies] and to deregulate the banks. China wants interest rates on deposits to be more attractive. At current rates, depositors aren’t paid even the rate of inflation. This means that banks will, in effect, have to bid for depositors by paying higher interest rates. That is similar to what caused the U.S. savings and loan [S&amp;L] crisis in the 1980s. We allowed S&amp;Ls to pay higher rates, and they had to make riskier investments to pay those rates.</p>
<p style="font-size: 12px;">The same thing could happen in China. Allowing rates on deposits to rise will compress banks’ profit margins, which could lead them to make fewer but riskier loans in order to maintain profit margins. So that could become a problem.</p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;By shutting down shadow banking, China is reducing liquidity and access to funds, and so if companies lack access to capital, the economy will slow down and some companies will go into distress, as one large real estate developer did recently. That’s more likely than in the past because as part of the economic reforms, the government is no longer going to stand behind these quasi-government companies if they run into trouble. The government may ultimately still help them, but there would be fear that it would not. &nbsp;</p>
<p style="font-size: 12px;"><b>Linsen:</b>&nbsp;This could all be good for U.S. consumers and the U.S. stock market. Slower growth puts less pressure on commodities prices, and that puts less pressure on inflation, which puts less pressure on the Fed to raise interest rates, which puts less pressure on U.S. consumers. That could contribute to an environment of sustained growth for some years.</p>
<p style="font-size: 12px;"><b>Brown:</b> Investors should understand that the impact of Fed policy on emerging markets is indirect. Often it is reported that the Fed created money, and that that money flowed into emerging markets. But it is not that straightforward. The Fed creates the money, and that lowers our interest rates, including those on high-yield bonds. That enables higher-risk companies, such as those in emerging markets, to issue debt at lower rates.</p>
<p style="font-size: 12px;"><b>Linsen:&nbsp;</b>Harold, the Japanese stock market has been under pressure this year. Are you concerned about the inflation that the government’s policies could create?</p>
<p style="font-size: 12px;"><b>Sharon: </b>The inflation rate is still not quite 1%, so maybe the central bank will become more active. That’s the expectation for later this year, when the consumer tax increases by a couple of percentage points in April.</p>
<p style="font-size: 12px;">The stock market has been stalling because GDP growth has been weak and there is less of a tailwind from the weak yen boosting corporate profits. So we’re in the difficult part of the economic restructuring&nbsp; plan because now it’s necessary for the government to make the structural reforms needed to keep the economy growing.</p>
<p style="font-size: 12px;">One bright spot has been that corporate sales growth on an annualized basis is about 3.8%, according to the Ministry of Finance. Hopefully, corporations will pass some of that along in the form of wage increases. But at this point, the economy really has been disappointing.</p>
<p style="font-size: 12px;"><b>Brown</b> I think that without structural reforms, Prime Minister Shinzo Abe’s economic plan [known as “Abenomics”] will fall apart. When the new consumption tax takes effect in April, that likely will boost inflation and, at the same time, slow economic growth. The government’s fiscal stimulus will also end in April. So, Japan could be on the brink of slower growth without the reforms that would have improved its global competitiveness and increase in exports.</p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;The Japanese are well aware that the economy needs structural reforms, such as changes to bring more women into the workforce. That’s necessary for Japan to deal with its demographic problem. But the Abenomics strategy of driving down the value of the yen in order to boost exports is misguided. One person in five is over the age of 65, so Japan is running out of workers, making it difficult to continue being the “workshop of the world.”<sup>5</sup></p>
<p style="font-size: 12px;"><b>Linsen:&nbsp;</b>As Japan’s population gets older, with more people beginning to live off their savings, what is that likely to do to Japan’s access to low-cost debt?</p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;It compounds the debt problem. The savings rate is already much lower than it has been historically. For years, the Japanese had a very high savings rate, and it mostly went into the postal savings system, which paid very low interest rates. So the Japanese government was, in effect, getting the debt almost for free. And now those savers are beginning to draw down on those savings.</p>
<p style="font-size: 12px;"><b>Brown:</b>&nbsp;So Japan will have to pay higher interest rates in order for new investors to lend the money that has come from Japanese savers in the past.</p>
<p><b style="font-size: 12px;">Linsen:</b><span style="font-size: 12px;">&nbsp;And what does that do to the interest expense on the debt, which amounts to 250% of GDP?</span><sup>6</sup><span style="font-size: 12px;">&nbsp;That would seem to be one of the risks that could bubble up in the next few years.</span></p>
<p style="font-size: 12px;"><b>Sharon:</b>&nbsp;That would create a debt spiral. That is the argument that Abe makes for the structural reforms. That is, if Japan doesn’t achieve some reforms, the economy won’t grow, and then the huge debt burden will become a problem.</p>
<p style="font-size: 12px;"><b>Ezrati:</b>&nbsp;Japan has an extremely top-down economy, and it needs to turn from an export-based economy to a consumption-based one [the same way China’s economy is]. So, Abe should probably be talking up the yen so consumers can buy more overseas.</p>
<p style="font-size: 12px;">Japan should also encourage a more entrepreneurial culture and break up the Iron Triangle, which consists of big business, the Japan’s dominant political party, and bureaucrats in the government. In an economy dominated by this Iron Triangle, entrepreneurs won’t be allowed in.</p>
<p style="font-size: 12px;"><b>Thank you.<br>
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<p style="font-size: 12px;"><span class="legal"><sup>1</sup>&nbsp;Sources: mortgage rates: Freddie Mac; existing home sales: National Association of Realtors®; home construction: U.S. Census Bureau; home prices: Case-Shiller Home Price Index.<br>
<sup>2</sup>&nbsp;U.S. Census Bureau. &nbsp;<br>
<sup>3</sup> Source: Bloomberg.&nbsp;<br>
<sup>4</sup>&nbsp;National Bank of Ukraine, as of October 1, 2013.<br>
<sup>5</sup> Ministry of Internal Affairs and Communication of Japan.<br>
<sup>6</sup> International Monetary Fund.</span><br>
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Mon, 14 Apr 2014 15:30:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/income-inequality-beyond-the-rhetoric.htmlIncome Inequality: Beyond the Rhetoric<div class="everything">
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<h3><i>While the topic has generated enormous controversy, what’s needed is a clear, dispassionate approach to identifying the causes—and potential solutions.</i><b></b></h3>
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<p>President Barack Obama in this election season has raised the nation’s consciousness of income inequality. Such concerns, however, are hardly new. Scholars, commentators, and working people have been talking about the widening gap between higher-income and lower-income earners for years now. The president has looked for a cause in greed and injustice. No doubt these perennial evils have contributed, but dispassionate research points elsewhere—to globalization and advancing technology—to explain the growing income gap. Relief, then, will come less from ridding society of sin and misdeed and more from finding ways to cope with the inexorable trends that have caused the income gap. Improved education and worker training provide answers. &nbsp;&nbsp;</p>
<p><b>The Evidence<br>
</b>The evidence of a widening income gap is powerful. During the last 20-some years, the incomes of the richest tenth of the country have grown five times faster than the incomes of the bottom fifth. The nominal earnings of the top 5% of the income distribution have grown a robust 9% a year, while the earnings of the bottom 5% have actually suffered an average annual decline of 2.5%. The richest 25% of the country now, on average, have annual incomes 15 times those among the bottom 25%, up from 10 times in the mid-1970s. Meanwhile, the Internal Revenue Service (IRS) has noted that the top 1.0% of the country earns 22% of the nation’s income, actually exceeding the previous high of 20% in 2000. Meanwhile, the bottom 50% of the income distribution earns a mere 12.8% of the total, down from its previous low of 13% set in 2000.<sup>1</sup></p>
<p>Some analysis takes exception to these measurements. This work points out, quite rightly, that because these data are drawn from tax statistics, they miss much and, consequently, overstate the gap. Fringe benefits for workers constitute some of what they miss. Because pensions and employer-provided health insurance are paid outside taxable income, they do not count in these IRS figures. Especially since such fringe benefits constitute a larger part of the total compensation of lower-income than higher-income employees, their inclusion would tend to narrow the compensation gap. Government transfers, such as the earned-income tax credit, child care benefits, and the like have a similar effect. These, too, do not appear in the tax data. Since all accrue to those at the lower end of the income distribution and not at all to those at the upper end, an accounting for them would tend to narrow the recorded income gap as well. They affect the trend, too, as such benefits have grown in significance over time. &nbsp;</p>
<p>Also casting doubt on these summary measures is a novel U.S. Treasury study. The Treasury, in order to gauge how families move between groups in the income distribution, actually followed the incomes of specific households over decades. While it identified the growing gap between high pay and low on average, it also discovered that most families move from one bracket to the other. Over the 10-year stretch, 1996 and 2006, the incomes of those who started in the lowest quartile of the income distribution rose a comparatively fast 6.7% a year on average, as they advanced through the income distribution, far faster than the 1.5% gains showed by those who started in the highest quartile of the distribution. Those advancing were, of course, replaced in that bottom quartile by those just starting their careers or those who suffered some unfortunate setback. The Treasury concluded from this analysis that the widening income gap might well capture the fact that experience was becoming more highly rewarded next to starting salaries than previously. &nbsp; &nbsp;</p>
<p><b>Causes<br>
</b>If there is ample room for dispute on the specifics, there is still enough evidence of a growing income gap to raise questions about the causes. Of course, it suits certain political objectives to find the cause in the evil of others, almost always one’s political foes. But without condoning or ignoring sin, research, as indicated earlier, finds the fundamental causes in globalization and the advance of technology. They are interlinked. &nbsp;&nbsp;</p>
<p>The impact of globalization has received more media attention. Because it is so much cheaper to produce some products in China, India, and other emerging economies, managements have sent the factories, mills, etc., overseas, throwing thousands out of their former positions into lower-paying jobs or simply onto unemployment rolls. And because the competition from emerging economies is most intense among the simpler products—toys, textiles low-level call centers, and the like—this burden has fallen most heavily on the less skilled and lower-paid in society. Even when the factories, workshops, and offices have remained in place domestically, the threat of a move abroad has constrained wage demands and so has slowed earnings growth at the lower end of the income distribution. Meanwhile, the greater profitability gained by the transfer to lower-wage workers overseas and the restraint exercised on wages domestically has accrued to the salaries and bonuses of management, boosting the income growth at the top of the income distribution.</p>
<p>Technology has reinforced this effect. Indeed, to the extent that firms have responded to foreign competition by upgrading for greater productivity, the globalization has accelerated the pace at which firms apply such technologies. Whatever the motivation for the technological upgrades, however, the effect is much the same. Because the technology—robotics, systems, and the like—tends to substitute for more routine, repetitive functions, it tends to throw more lower-wage than higher-wage people out of work, with similar effects on income when production moves overseas. Also in a similar way to foreign competition, the threat of a technological solution has also restrained the wage demands of those still employed, especially in lower-income occupations. And also as with globalization, the systems, robotics, etc., enhance the productivity and reach of management, fostering more rapid compensation growth at the top of the wage distribution.</p>
<p>Scholarly work has tried to disentangle these effects. Most of it attaches the greater impact from technology than globalization, tying some 70% of the lost jobs and wage shortfall to it. But because these influences are intertwined, any such effort to distinguish the impact of one from the other is tenuous at best. But in the public’s mind, it hardly matters. People can see that jobs have been lost, particularly in the simpler functions that have long securely employed millions. They can sense that the rich are getting richer and the poor, if not getting poorer absolutely, are losing their share of national prosperity. They want a solution. Since neither globalization nor technology is stoppable, at least not without causing a good deal more pain to an even larger part of the population, the answer lies in helping people find ways to cope with the trends.</p>
<p><b>Answers<br>
</b>In both cases, job security and income growth depend on an upgrading of worker skills. The object is to serve a more innovative economy, to enable it and each worker to cope with technology, and to produce higher-value product that can support the higher wages earned in this country and expand them over time. The president and many others in Washington have stressed education in math, science, and technology. These certainly have a role in the needed process, but the reality of the situation is more complex and so actually offers more opportunity for individuals, firms, and government to improve the situation.</p>
<p>The most effective response is evident in the nature of innovation. There is, of course, a crucial need for scientists, engineers, and those with advanced technical skills. They make the underlying technological advances. But in order for the engineers’ inventions to have an economic effect, society needs a second aspect to innovation, less discussed but equally important: the sometimes seemingly chaotic efforts of millions of often low-technology skilled people to combine new technologies with old in order to serve particular economic needs or productive efficiencies, often in ways never considered by the scientists and engineers who developed the original technologies.</p>
<p>The educational establishment must produce these people as well as scientists, engineers, and mathematicians. They demand very different educational support. While technical skills require intensive study and instruction, these other contributions require people who think more extensively, an ability cultivated through very different academic disciplines and training than are technical skills. Rather than Washington’s single-minded and simplistic focus on math, science, engineering, and technology, the educational establishment can only meet these needs by also providing courses and support for these other, necessarily broad-based skills and abilities. It is noteworthy in this respect that Apple’s Steve Jobs had far less technical skill than most of his employees, but contributed mightily to his firm’s and the economy’s success by sensing market needs and opportunities and applying technologies accordingly.</p>
<p>Nor is this more complex need restricted only to higher education. In worker training, too, there is a need for a similar sort of broad-based general upgrade. To some extent, workers themselves have already responded to the challenge. They can see what scholarly statistical analyses have verified: that better-trained workers have better job security, as good as 20–30 years ago, in fact, and enjoy better income prospects. Accordingly, workers have upgraded their skills so that the average employee today has 13 years of formal education and training, up from 10 years on average two decades ago. To counter the growing income disparity, this trend must become even more widespread. And, as with higher education, it needs to embrace more than just technical skills. High-value, technically advanced production also needs workers who can adjust to changing circumstances as well as communicate with each other, with management, and, because so much high-value production contains an element of customization, with customers as well.</p>
<p>Even if the nation’s efforts at education and training rise successfully to meet this need, a portion of the population inevitably will fall short. For various reasons—lack of cognitive skills, lost opportunities, or just bad luck—they will miss the upgrade. For them, the economy will always have a need for low-skilled occupations, less than previously, of course, because of foreign competition and technology, and less remunerative, but a need nonetheless. It may be that this group will need public assistance to supplement low wages or substitute where such work is unavailable. Because it will take a broadly rich economy to provide such support, the innovation, as well as upgraded education and training, becomes still more important to create the wealth needed to provide such assistance.&nbsp;<br>
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<p><span class="legal">*I would like to thank Lord Abbett Regional Manager Casey Miller for suggesting this line of analysis.<br>
<sup>1</sup><span style="font-size: 11px;">All data from Milton Ezrati, </span><i style="font-size: 11px;">Thirty Tomorrows</i><span style="font-size: 11px;"> (St. Martin’s Press/Thomas Dunne Books, 2014).</span></span></p>
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Mon, 14 Apr 2014 10:01:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/china-the-yuan-puzzle.htmlChina: The Yuan Puzzle<div class="everything heading">
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<h3><i>What is behind Beijing’s abrupt shifts in policy regarding the currency’s value?</i></h3>
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<p>When it comes to currency policy, China these days seems even more of an enigma than usual. The yuan’s behavior has left questions about exactly where the county’s leadership wants things to go. Earlier, things were clear. China held its yuan rigidly cheap to the dollar in order to promote exports. But starting in 2005, signaling a policy change, the People’s Bank of China (PBC) allowed a very controlled appreciation in the yuan. That halted abruptly in the second half of 2008, when the PBC returned to rigid control until 2010, when the appreciation resumed. It continued more or less steadily, except for a pause in the middle quarters of 2012, until this year, when, in early March, the PBC abruptly entered foreign exchange markets to drive down the yuan’s dollar price, significantly, given past behavior. The authorities have pushed it down since.<sup>1</sup>&nbsp; &nbsp; &nbsp;&nbsp;</p>
<p>Against such a backdrop, it is only reasonable for people to question PBC policy. As is often the case when behavior looks erratic, it likely reflects the play of two contradictory objectives. On the one hand, the authorities want to keep the yuan cheap to the dollar in order to promote Chinese exports, the county’s chief source of employment growth for some time now. On the other, China realizes that it cannot count on exports indefinitely, that it needs to engage a domestic growth engine, and yuan appreciation and internationalization serves that purpose, as well as Beijing’s perennial desire for greater global prestige and power. Since 2005, this latter objective has dominated, though in periods of economic adversity, Beijing readily retreats into its older, “cheap yuan, pro-export” posture. No doubt, this on-again/off-again pattern will persist for some time to come, slowing the pace of yuan internationalization and delaying the day when the yuan can present itself as a reserve currency, much less as a replacement for the dollar. &nbsp; &nbsp;&nbsp;</p>
<p><b>Why Change at All?<br>
</b>China’s present currency policy has practical and aspirational as well as accidental roots. On the practical side, the authorities have realized that export-led growth cannot go on indefinitely. The PBC signaled this realization in a 2005 paper, “The Timing, Path, and Strategies of RMB Internationalization,” which, along with other Chinese government research, pointed out that Chinese exports had limits. They had risen from a negligible part of the global trade in the mid-1990s to fully 12%. A comparable expansion was all but impossible over the next 10 years, especially given the increased pressure on China from the United States and the European Union. Rather than fight the rest of the world, as well as practical probabilities, these papers recommended that China seek to supplement exports with a more domestic growth engine. Pursuing that objective and seemingly bowing to the pressure from Washington and Europe, the PBC began to allow the yuan to appreciate, though in an extremely cautious gradual way.<sup>2</sup></p>
<p>Events surrounding the 2008–09 financial crisis and recession accidentally reinforced this decision. On one side, they demonstrated the vulnerability of the export-based growth model. As the global economy sank and China’s exports fell, layoffs in China came fast, and social unrest, including considerable rioting and anti-government violence, followed just as quickly. Beijing awakened to how susceptible its economy was to events outside its control. An additional and unexpected insight emerged when the government tried to relieve the economic pressure with massive infrastructure spending beginning in 2008. These outlays were meant primarily as a temporary, substitute jobs program, but they had such a remarkably positive economic response that Beijing could not help but see the great economic potential of broad-based development away from the established, coastal export centers.</p>
<p>Free to contemplate a future in which the PBC no longer had to support exports by keeping the yuan cheap, the authorities in Beijing came to see other benefits of a stronger yuan, one that could become a truly international currency, held and traded widely in the world’s financial centers, maybe even a reserve currency held by central banks. Such a role was of course impossible while China’s policy stressed exports and a cheap-yuan policy, since an international currency, much less a reserve currency, always trades at richer prices than it otherwise might.&nbsp; With less fear of a strengthening yuan, Beijing embraced at least five other benefits from an internationalized yuan.<sup>3</sup></p>
<p>1. A widely traded currency and one held overseas would reduce transactions costs for Chinese business.</p>
<p>2. More international contracts denominated in yuan would reduce exchange risk for China-based businesses.</p>
<p>3. When foreigners, including central banks, hold yuan, China can buy goods and services without having to exchange its own products in return. This <i>seigniorage</i>, as it is called, is something the United States has enjoyed for all these years that the dollar has served as international currency generally and especially as the world’s leading reserve currency.</p>
<p>4. With the yuan held abroad, China’s macroeconomic policies have greater flexibility because they no longer have an immediate reflection in trade flows.</p>
<p>5. The more of a presence the yuan has in trade and global financial dealings, the greater prestige and influence Beijing enjoys. &nbsp;&nbsp;</p>
<p><b>Beijing’s Strategy and Its Failures<br>
</b>China’s leadership has approached this effort to internationalize the yuan with great caution. It has at least three reasons. One is the gradualism Beijing has always shown in just about everything it does. Second is the ongoing effort to protect China’s still-important export industries, at least until China’s domestic growth engine could fully develop. Third is Beijing’s concern that the open, broad financial market needed to support an international currency will interfere with its ever-present desire for top-down control.<sup>4 </sup>&nbsp; &nbsp;</p>
<p>The second of these considerations rears its head whenever economic trouble appears. Protecting its export share remains China’s failsafe position. As much promise as domestic development offers, Beijing knows that it will be a long time before it can replace exports as the prime driver of China’s economy and that China has much to do before consumption and other domestic economic activities can fully substitute for exports, or even supplement them adequately. Consumption, for instance, constitutes a mere 30% of the economy, compared with 70% in the United States, for example. Though a rising yuan value will help adjust the mix toward domestic efforts, by holding down domestic rates of inflation and encouraging consumer spending, among other things, the existing reality keeps the authorities alert to any yuan rise that could harm exports unduly in the interim.&nbsp; Such concerns will prevail for a long time to come.</p>
<p>Accordingly, the PBC has engineered only the most gradual yuan appreciation, one that it is willing to stop whenever the country faces adverse economic or financial conditions. Thus, when the global recession of 2008–09 threatened China’s export industry, the authorities put long-term yuan appreciation efforts on hold in order to secure a greater share of the then shrinking global export market. The highest reaches of the Communist party made that goal clear. The PBC blocked even the least yuan appreciation until 2010, when Beijing was sure that the worst of the global recession had lifted. Then again, in the middle quarters of 2012, when China’s economy seemed to weaken and it faced questions about financial stability, the PBC again stopped the yuan’s advance, only allowing it to resume when the economic and financial clouds lifted. Perhaps this latest move by the PBC to drive down the yuan’s price reflects the recent news of Chinese economic weakness. But this latest move also seems to reflect something else, very likely Beijing’s need to grapple more than previously with the financial ramifications of its efforts to internationalize the yuan.</p>
<p>Until recently, Beijing has approached the financial side of the yuan’s internationalization largely through aspects of trade finance. The PBC, has, for instance, set up currency swap agreements with a number of other central banks to increase yuan liquidity in support of the country’s trade. In a similar way, Beijing has gradually widened the trade transactions eligible for settlement in yuan and simultaneously increased the amount of export invoicing denominated in yuan. This has gone reasonably smoothly. It is the asset side of the financial support that has gone less smoothly largely because it conflicts with Beijing’s other desire for control. So, for example, the offshore yuan bond market (colloquially called the “Dim-Sum” market), though essential for the full internationalization of the yuan, has grown only slowly, largely because Beijing has continued to try to insulate its domestic financial markets from it with stark limits on how much bond issuers can use the yuan proceeds in China. Similarly, the “Panda” bond market, set up for foreign firms to issue yuan-denominated bonds in Shanghai, has failed to take off because of similar, conflicting, official controls. The recent decision by Beijing to control lending by effectively shutting down China’s shadow banking system in favor of state-run banks is of a piece with these other positions. A more open system would have managed the situation through more conventional monetary policy tools.&nbsp;</p>
<p>This approach to finance might help protect China from the bad loans that could cause havoc in a different structure, but it also will prevent the full internationalization of the yuan. No currency can gain global attention, much less become a reserve currency, unless economic agents across the globe can use it freely in accounts, borrow it freely from financial institutions or through bond issuance inside the country and outside it, and trade assets denominated in it just as freely. To create such milieu, Beijing will need to let borrowers and lenders, domestic and foreign, enter and leave markets easily and use monies raised for a wide variety of purposes, alongside state banks, even with them. As long as the authorities thwart such movements for whatever reason, the yuan will fall short internationally, even relative to China’s trade or the size of its economy. The yuan will pale as a reserve currency, much less challenge the dollar.<br>
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<p><span class="legal"><sup>1</sup> Information from Bloomberg.<br>
<sup>2</sup> Benjamin J. Cohen, “The Yuan Tomorrow?” unpublished paper, 2011.<br>
<sup>3</sup> Ibid.<br>
<sup>4</sup> All information and data here and afterward from Milton Ezrati, <i>Thirty Tomorrows</i> (Thomas Dunne/St. Martin’s Press; forthcoming April 2014), especially Chapter 14.</span></p>
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Mon, 7 Apr 2014 04:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/Tax-Reform-Camp-Fires-Up-the-Debate.htmlTax Reform: Camp Fires Up the Debate<div class="everything heading">
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<h3>Chances for passage of the congressman’s overhaul of the U.S. tax code are slim, but provisions of the bill could point the way to future reform.&nbsp;</h3>
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<p>Tax reform has reentered the headlines with the announcement of a plan from Representative Dave Camp (R-MI), chairman of the House Ways and Means Committee. This is a welcome development, for the present U.S. tax code is hopelessly complex, grossly inequitable, and generally tends to stymie growth. Even so, Mr. Camp’s bill is not likely to pass, this year certainly or perhaps ever. The debate over it, however, can advance the general reform effort, pointing out what is necessary and what can work practically, from either an economic or a political angle.<sup>1</sup>&nbsp; &nbsp;</p>
<p><b>What Congressman Camp Has Proposed<br>
</b>To bridge between Republicans, who want to reduce Washington’s take, and Democrats, who want to increase and redistribute it, Mr. Camp’s proposals, he claims, would be revenue and distribution neutral. This, of course, is no place to go through all the many provisions of his 979-page bill. In general, it would do six things:</p>
<p>1) By standardizing breaks on education, child care, and the like, and by eliminating alternative minimum tax, it would relieve the bulk of the population of the need to itemize.</p>
<p>2) It would reduce today’s seven individual income tax brackets to three, set at 10%, 25%, and 35%. He claims that 99% of the nation’s taxpayers would fit in the first two brackets.</p>
<p>3) The corporate tax would fall from 35% to 25%, and the proposed code would encourage companies to repatriate foreign earnings by eliminating or reducing the tax rates on such monies.</p>
<p>4) Camp’s previsions would tax all “productive income” at the corporate, 25% rate by equalizing the tax treatment of all businesses, subchapter(s), and “pass through” alike.</p>
<p>5) Though the bill would slow some of the accelerated depreciation presently allowed, it would make permanent the research and development (R&amp;D) tax credit.</p>
<p>6) To make up the revenue shortfall from the tax-rate reductions, this proposed code would eliminate many current tax breaks and preferences for individuals and companies.</p>
<p>Congress’s Joint Tax Committee scores the bill favorably. Unlike past practice, these calculations account for the bill’s likely growth effects. In the past, scoring has ignored such considerations, sticking to a so-called static approach. The bill’s claim of revenue neutrality uses a static calculation. But the committee’s consideration of growth concludes that Camp’s proposals would create 1.8 million new jobs and add $3.4 trillion to economic growth, including an additional $700 billion to federal receipts over the next decade. It is encouraging that this dynamic scoring approach (if not Mr. Camp’s proposals) has received bipartisan support, most importantly and enthusiastically from Senator Ron Wyden (D-OR), chairman of the Senate Finance Committee, who referred to the adoption of dynamic scoring by the Congressional Budget Office as a “breakthrough” on tax reform. &nbsp; &nbsp;&nbsp;</p>
<p><b>Prospects<br>
</b>Still, for all the hard work done by Representative Camp and his committee, or the favorable scoring, passage is unlikely. Political pundits point out that neither Democrats nor Republicans have much appetite for dramatic legislation in an election year as fraught as this one. Democrats will have an especially hard time endorsing these reforms while campaigning on income inequality. President Obama will likely reject it as well and for the same reasons. For all the static revenue neutrality and dynamic revenue gains it promises, the president has made clear that he will gladly forego revenues and even economic growth rather than “unfairly” lower tax rates on the wealthy, and this bill would reduce the top individual income tax rate from 39.6% presently to 35%.</p>
<p>The proposed legislation also would face resistance because it eliminates tax benefits and breaks for powerful interest groups. Here, the list is long:</p>
<p>1) Though the bill would continue all existing mortgage interest deductions, it would disallow deductions going forward on mortgage amounts above $500,000. High-income earners might not mind, given that the bill also gives them a reduction on their income tax rate, but builders would lobby against this provision, as would representatives from states where property is more expensive.</p>
<p>2) High-tax states also would resist Camp’s desire to end deductions for state income and property taxes.</p>
<p>3) The bill’s proposals on municipal bonds would also face resistance. It seeks to limit to 25% the tax break provided by municipal bond income and impose a10% surtax on municipal bond interest received by high-income taxpayers. Wealthy retirees especially would resist such provisions. Because changes would definitely raise the borrowing costs of states and municipalities, they would also stir resistance among the 50 state legislatures and 50 politically potent state governors.</p>
<p>4) The provision to cap itemized deductions for individuals making more than $400,000 a year and eliminate the charitable deduction until it exceeds the 2% of income might generate only passing resistance among wealthy taxpayers, but it would excite intense resistance among powerful charity and nonprofit lobbies.</p>
<p>5) The bill would encounter taxpayer resistance by raising the top rate on capital gains, from the 23.8% just recently imposed to 24.8%. A similar resistance, plus objections from pensions or providers, would rise from the bill’s proposal to cap the amounts wealthy individuals could place in tax-protected retirement accounts. Meanwhile, insurers and individuals would resist the provision to impose a 10% tax on work-provided healthcare plans.</p>
<p>6) Because the bill would eliminate cash accounting for large and mid-sized professional firms, it would generate particular resistance from doctors, lawyers, and accountants, all three of which are renowned for their lobbying power.</p>
<p>7) While corporations would surely welcome the decline in the tax rates on their overall and foreign earnings, some or all would resist provisions to: a) place a special excise tax on large, presumably systemically important banks; b) eliminate $4 billion in tax subsidies for oil, gas, and other fossil fuel providers; c) end carried interest; d) eliminate all the complicated tax benefits the present code gives alternative energy producers; e) reduce further the deductible portion of business meals and entertainment; f) impose a very complex formula to define which efforts are eligible for the R&amp;D tax credit and entirely exclude violent videogames from the exemption; and g) impose a minimum tax on income above 10% of the value of plant and equipment.</p>
<p>8) The ultimate in broad-based resistance would surely arise from the bill’s proposal to take away the tax-exempt status of the front office of the National Football League.</p>
<p>If all this, and it is only a partial list, renders Camp’s legislation, as the political pundits seem to agree, dead on arrival, the effort nonetheless has value. It keeps the need for reform at the front of people’s minds, both in government and outside it, and it informs all which measures can gain support and which cannot. The debate will also refine people’s understanding of which provisions promote equity, efficiency, and simplicity at acceptable costs and which do not. The fate of the proposals and debates on them will also make clear how much genuine tax reform requires bipartisan support, such as existed during the last successful reform effort in 1986. This need is especially critical when it comes to simplification, for Camp’s huge bill can only be considered simple when set next to the existing monstrosity.</p>
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<p><span class="legal"><sup>1</sup>All the facts are drawn from four articles, each used to enhance and verify what the other said: Douglas Holtz-Eakin, “Reforming Taxes, Goosing the Economy,”&nbsp;<i>The Wall Street Journal</i>, March 6, 2014; “Tax Reform for Growth,” editorial,&nbsp;<i>The Wall Street Journal</i>, February 27, 2014; Martin Sullivan, “25 Interesting Features of Chairman Camp’s New Tax Reform Plan,”&nbsp;<i>Forbes</i>, March 3, 2014; and “Factbox: On U.S. Tax Reform, Obama and Republican Rival on Same Page,”&nbsp;<i>Reuters</i>, March 4, 2014.</span></p>
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Mon, 31 Mar 2014 04:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/stocks-aging-bull-could-still-pack-a-punch.htmlStocks: "Aging Bull" Could Still Pack a Punch<div class="everything heading">
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<h3>Bearish market observers fret that earnings growth will falter and that current equity valuations are unsustainable. Their worries are misplaced.</h3>
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<p>Equity valuations, though not as drop-dead gorgeous as they once were, still look attractive enough to produce good equity gains going forward. Even so, many in the financial community hesitate, citing two interlinked objections in particular. One suggests that corporate earnings are unsustainable, that recent gains are the result of cost cutting and will eventually fail. The second reflects back on the suspect earnings and questions whether price-to-earnings (P/E)<sup>1</sup> multiples can hold existing levels. Both objections, though understandable, miss critical considerations. To start, corporate earnings, though they have outpaced revenues growth, are not, as so many suggest, the product of unsustainable cost cutting. Rather, they are the solid, reliable result of operating leverage in American business. They have a reflection in all past recoveries and, if anything, likely will continue, at least to some degree. They certainly are not likely to fail. That fact alone makes multiples look more secure, but even more, historical relative valuations suggest that they have room to expand.</p>
<p><b>Reliable Earnings<br>
</b>The main fear on earnings lies in how they have outpaced revenues. In 2010, for instance, the first full year of economic recovery, the earnings of companies in the S&amp;P 500<sup>®</sup> Index<sup>2</sup> rose 49.5%, far faster than revenues, which expanded only 6.0%. In 2011–12, the difference between earnings and revenues growth narrowed, but still, over the entire three-year stretch through 2012, the gap remained large. Earnings grew at an annual rate of about 17.0%, while revenues expanded at only a 6.3% rate. Last year, earnings outpaced revenues again, expanding about 11.0% on preliminary figures, compared to only 3.6% growth in revenues.<sup>3</sup></p>
<p>It is easy to see in these differences why many have worried that earnings have a less than solid base. But the popular explanation that they result from unsustainable cost cutting misses the mark. Such differences are too vast to yield to suggestions, as some have made, that managements engineered this earnings surge by cutting out frills, such as first-class travel, or essentials, such as maintenance. Even suggestions that they have held back on bonuses cannot explain the difference. On the contrary, the huge disparity between earnings and revenues growth invites a more fundamental, durable, and reliable explanation. The answer is operating leverage.</p>
<p>This is fundamental, especially in the United States, where business is highly capital-intensive.&nbsp;<a href="https://www.lordabbett.com/advisor/commentary/investmentperspectives/return-on-robots/">Robotics</a>, computers, systems, and other facilities allow companies to do more with fewer employees. The effort has enhanced productivity, efficiency, and profitability. At the same time, however, it has raised fixed costs, for whether times are good or bad, whether firms use the powerful equipment and systems or not, they must continue to pay, to maintain them, and to service the debt they often incurred to obtain them. When times are good and all this equipment is effectively employed, much of the revenue it generates flows to the bottom line instead of to the workers for whom it substituted. But when times are bad, firms cannot lay off the equipment, as they can workers, leaving much of the revenue shortfall to come out of the bottom line. Then in the recovery, as this equipment comes back on line, the earnings catch up. And because the revenues number is huge compared to the profits number, the percentage moves in earnings, up and down, are vast. &nbsp; &nbsp;</p>
<p>The pattern is evident in this cycle. In the last great recession, as revenues fell 16.5% from the September quarter of 2008 to the December quarter of 2009, the fixed costs brought most of this loss to the bottom line, creating a more extended drop in earning that from its peak in the June quarter of 2007 to its trough in the June quarter of 2009 amounted to more than 90%. But as even the sluggish recovery that followed began to bring this equipment back on line, almost all the additional revenues flowed into earnings having the opposite, positive impact described above.&nbsp;<br>
<span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Chart 1. Earnings versus Revenue</span><br>
</b><i>Year-over-year percent change</i></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/EI%203.24_Ch.1C882A9.jpg"></p>
<p><span class="legal">Source: FactSet.<br>
*Uses national income and product account proxy for revenues growth.</span><br>
<span class="separator">&nbsp;</span></p>
<p>The same pattern is evident in past cycles, as Chart 1 makes clear. In the 2001–02 recession, for instance, revenues only flattened out, but operating leverage caused a 30.8% collapse in the annual averages of earnings used here. But, then, also consistent with the pattern, earnings came back stronger in the recovery, jumping at a 17.7% annual rate from 2001 through 2006, while revenues expand only about 6.0% a year. The same picture emerges going even further back. In the 1974–75 recession, for instance, real economic activity shrank by 1.2% cumulatively, though the high inflation of the day, more than 9% at an annual rate, kept the nominal revenues figure rising. Earnings, however, fell 17.5% in 1975. And consistent with the effect of operating leverage, earnings in the recovery outstripped revenues, rising almost 19% a year for the next two years. Much was inflation, of course, which nonetheless accounted for a far greater proportion of the 11.1% revenues growth.&nbsp;</p>
<p><b>Attractive Multiples<br>
</b>If, as should be apparent, the earnings figures are a reflection of basic business gains, then existing multiples look far more secure than some suggest.&nbsp; Beyond secure, several additional considerations suggest that they could easily move upward. For one, today’s prices, at some 17.4 times last year’s earnings, or 16.5 times consensus for this year, hover close to the long-term, 35-year average, as Chart 2 illustrates. Stocks at worse, then, can be described as fairly valued and at worst should track earnings. For another, the natural cyclical pattern of multiples, as the chart also shows, usually carry them through the long-term average as they advance from lows. On this basis, the historical pattern would suggest further multiples gains. Still more compelling, stock valuations relative to bonds and cash show ample room for a multiples advance. &nbsp;<br>
<span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Chart 2. S&amp;P 500 Index Price-to-Earnings Multiple</span><br>
</b><i>Annual figures, same year earnings</i></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/EI%203.24_Ch.2C882F9.jpg"></p>
<p><span class="legal">Source: FactSet.<br>
</span><span class="separator">&nbsp;</span></p>
<p>The difference relative to cash is striking.&nbsp; Today, the best an investor can do with cash is to get 30 basis points (bps). Against that, the stocks in the S&amp;P 500, even after last year’s impressive market gains, offer a dividend yield of just less than 2.0%. As Chart 3 reveals, short rates typically run higher than dividend yields, not dramatically lower, as they are today. In fact, short rates on average over the last 35 years or so have stood a bit more than 200 bps <i>above </i>the index’s dividend yield. Even in the unlikely event that firms add no more to their dividends, the equity market in this context could not rise enough to reestablish this historical norm. Obviously, this is no forecast, but it gives an idea of the extreme value imperative existing at the moment.</p>
<p>The comparisons to bonds are a little more complex, but no less compelling. The most common way to compare stock valuations to bonds is to invert the P/E multiple to express earnings as a yield on the price of stocks. This so-called earnings yield today stands near 6.0%, some 250 bps above the yield on the popular Barclays Corporate Bond Index.<sup>4</sup>&nbsp;But, as Chart 4 shows, bond yields typically run <i>above</i> the stock index’s earnings yield, not <i>below</i> it. Even in the unlikely event that earnings do not rise a jot and bond yields were to rise 150 bps, the multiple on the S&amp;P 500 would have to rise to 40 times to reestablish the historical relationship to bonds, for a gain of more than 140%. Again, such an adjustment is implausible over any reasonable time span, but it does nonetheless give an additional perspective on the value imperative.&nbsp;<br>
<span class="separator">&nbsp;</span></p>
<p><b><span class="rte_txt_green">Chart 3. S&amp;P 500 Index Dividend Yield versus Three-Month Bill Rate</span><br>
</b><i>Annual figures</i></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/EI%203.24_Ch.3C882F8.jpg"></p>
<p><span class="legal">Source: FactSet.</span><br>
<span class="separator">&nbsp;</span></p>
<p><b>Good to Great Return Prospects &nbsp;&nbsp;<br>
</b>No one pretends that these historical relationships will reestablish themselves anytime soon. There is a good chance, in fact, that rising bond yields and, in time, even rising short rates will begin to bring matters more into line from their side of the equation. But the gap is so vast that even in the face of rising rates and bond yields, it still gives ample room for a multiples expansion. It certainly leaves a powerful argument against any expectation of a drop in multiples, especially since at the same time the earnings figures look secure. With these parameters, it is possible to bracket market prospects using conservative and more aggressive assumptions.&nbsp;</p>
<p>On the conservative side, the place to start is with an assumption that the effect of operating leverage has run its course and that earnings going forward will only track revenues. There is actually every reason to expect operating leverage to continue to have its positive effect. According to the Federal Reserve, business still only uses 78.5% of its existing capacity, suggesting that firms have more to bring fully into production and so carry still more revenues to the bottom line. Even so, it suits a comfortable conservative baseline to assume an end to the operating leverage effect. On this basis, the consensus earnings growth expectation of about 6.0% this year looks about right. Nominal sales in the U.S. domestic market seem set to rise about 4%—2.5% real growth and 1.5% inflation. Since about half the S&amp;P earnings come from overseas, much in the emerging markets, the overall revenue figure should come in closer to 5.0%. The per-share figures should edge higher because firms are doing a lot of repurchasing. Buybacks, according to recent figures, are running about 2.7% a year of outstanding shares, but accounting for options exercised and stock bonus plans, a 1.0% drop in outstanding shares should serve as a conservative figure. That gets to the consensus per-share earnings growth of 6.0%.&nbsp;<br>
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<p><b><span class="rte_txt_green">Chart 4. S&amp;P 500 Index Earnings Yield versus Barclays Corporate Bond Yield</span><br>
</b><i>Annual figure</i></p>
<p><img src="/content/dam/lordabbett/en/images/articles/charts/EI%203.24_Ch.4C882F7.jpg"></p>
<p><span class="legal">Source: FactSet.</span><br>
<span class="separator">&nbsp;</span></p>
<p>If, to take a further conservative assumption, current multiples simply hold, then stock prices can rise in tandem with this expected 6.0% gain in earnings per share. The addition of the 1.9% dividend offered by the S&amp;P 500 would then allow equities to offer investors a total return of about 8.0%, not the great gains of 2013, to be sure, but attractive nonetheless, especially given the alternatives in cash and bonds and that this is a conservative, baseline expectation.&nbsp;</p>
<p>But, of course, the above analysis shows that there is ample room for multiples to do considerably better than just hold at present levels. Without even suggesting additional help to earnings from operating leverage or that normal relationships to cash and bonds get reestablished anytime soon, a gain in multiples is far from out of the question, even as bond yields rise. Just for the sake of perspective, then, here are the total returns associated with various moves in multiples: &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;</p>
<p><b>Assumption &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; Total Equity Return</b></p>
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<tbody><tr><td width="355" valign="top"><p>The conservative baseline described above assumes an end to the operating leverage effect and no multiples expansion</p>
</td>
<td width="283" valign="top">&nbsp; &nbsp; &nbsp; &nbsp; &nbsp;8%</td>
</tr><tr><td width="355" valign="top"><p>End to operating leverage effect and multiples move halfway to the 20x averaged in the 1990s</p>
</td>
<td width="283" valign="top">&nbsp; &nbsp; &nbsp; &nbsp; 13%</td>
</tr><tr><td width="355" valign="top"><p>End to operating leverage effect and multiples rise all the way to the 20x averaged in the 1990s</p>
</td>
<td width="283" valign="top">&nbsp; &nbsp; &nbsp; &nbsp; 24%</td>
</tr><tr><td width="355" valign="top"><p>End to operating leverage effect and multiples rise halfway to alignment with bonds after they have risen 150 basis points</p>
</td>
<td width="283" valign="top">&nbsp; &nbsp; &nbsp; &nbsp;104%</td>
</tr></tbody></table>
<p><span class="legal">Source: FactSet.</span></p>
<p>This is a wide range, and it shows the difficulty of any point forecast of the market. But it does give an idea of the potential, even in the absence of a lot of good news on economic activity or profitability.&nbsp;</p>
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<p><span class="legal"><sup>1</sup>The price-to-earnings (P/E) ratio, also known as the multiple, reflects how much a stock costs relative to its earnings. It is calculated by dividing the current stock price (the P) by the current earnings (the E). Forward-looking numbers in P/E Yr+1 are from IBES estimates at the relevant point in time.<br>
<sup>2</sup>All data within the article from FactSet.<br>
<sup>3</sup>The S&amp;P 500<sup>®</sup> Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.<br>
<sup>4</sup>The Barclays U.S. Corporate Bond Index includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt.&nbsp; The index is composed of both U.S. and Brady bonds.&nbsp;</span></p>
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Mon, 24 Mar 2014 04:00:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/is-the-feds-monetary-mojo-working-at-last.htmlIs the Fed's Monetary Mojo Working at Last?<div class="everything">
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<h3>It just might be. Data suggest that the central bank’s massive liquidity boost may be starting to flow into the broader economy.</h3>
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<p>It looks as though money is beginning to move.&nbsp; Both the narrow M1 definition of money and the broader M2 definition<sup>1</sup> have accelerated of late, suggesting that perhaps the tremendous amount of liquidity the Federal Reserve has poured into financial markets and onto financial institutions has at last begun to flow into the general economy.&nbsp; This movement, effectively from Wall Street to Main Street, will, if it persists, cheer businesses large and small, no doubt, and the unemployed.&nbsp; But the shift also will call Fed policymakers into action in order to secure control of the sea of liquidity they have provided so that it does not lead, as such liquidity flows have historically, to economic overheating and inflationary pressures.&nbsp; Matters are far from urgent, however, but such a movement, again if it lasts, could present investors with a very different Fed from the one to which they have grown accustomed.&nbsp; Perhaps the Fed’s new determination to taper the rate of quantitative easing reflects such a response, at least in part.</p>
<p><b>Accelerating Money Growth<br>
</b>The statistics may be revised, but what the investing public and the Fed have now is a picture of accelerating money growth.&nbsp;&nbsp; MI money has begun to grow much faster during the latter part of 2013 and into this new year.&nbsp; After a summer quarter, which saw an annualized M1 growth of barely more than 5%—not much different than the pace of expansion registered by nominal gross national product (GDP)—September saw the pace of M1 expansion jump to &nbsp;an annualized rate of almost 17%.&nbsp; Between January and mid- February 2014 (the most recent period for which complete statistics are available), growth averaged more than 25% at an annual rate.<sup>2</sup></p>
<p>Since the only way such an M1 acceleration occurs is through a growth in checking accounts, the pattern suggests that perhaps banks and the other financial institutions are finally lending and otherwise moving the ample reserves the Fed has provided for so long.&nbsp; The implication, then, though only preliminarily, is that the liquidity is flowing to businesses and individuals and so to the general economy.&nbsp; That conclusion gains some reinforcement from the figures on bank lending, which have jumped from an anemic 1.6% annualized rate of increase last spring and summer to about a 5.0% annual rate of advance during the three months ended in mid-February (the last period for which complete data are available).<sup>3</sup> This can hardly be described as a breakout, but it may serve as a harbinger. &nbsp; &nbsp;</p>
<p><b>Implications<br>
</b>On its face, the news speaks to the ultimate success of the Fed’s policy of monetary ease.&nbsp; Since the financial crisis and recession of 2008–09, the Fed has tried to bolster the economy, bringing short-term interest rates down to nearly zero and using three quantitative easing programs to redouble the economic lift by trying directly to depress longer-term bond yields.&nbsp; Bank reserves exploded in response to this policy, growing at an annualized rate of more than 25% between mid-2009 and into 2013.&nbsp; So did the so-called monetary base, which adds currency in circulation to the reserves total.&nbsp; It grew at an annualized rate of more than 17% during that same time.&nbsp; But great caution among financial institutions and business managers kept lending slow, effectively blocking the huge volume of liquidity from reaching the general economy.&nbsp; The money measures offered one sign of this blockage.&nbsp; Though they follow an erratic pattern, these measures grew at a much slower pace, on balance, than either reserves or the monetary base.&nbsp; Another sign was that bank lending, until very recently, hardly picked up at all. &nbsp;So little of this liquidity reached people and firms that, on average, some 95% of the reserves held by banks have been in excess of what was required to support their lending and deposits.<sup>4</sup>&nbsp; &nbsp;&nbsp;</p>
<p>Now, with the acceleration in money statistics and loans, policymakers might think that the funds at last are flowing where they wanted them to go all along.&nbsp; Investors who like to extrapolate can point to the change as justification for an expectation of accelerating the nominal and real economy, perhaps toward the faster pace associated with past economic recoveries.&nbsp; Policymakers who too like to extrapolate might see in this recent picture a need to begin to unwind the support of the past five years in order to keep matters from getting out of hand.&nbsp; The Fed’s determination to taper the extent of its ongoing and third quantitative easing program may reflect such thinking, among other considerations.&nbsp;&nbsp; For those investors and policymakers with a very long-term perspective, the trend might raise fears of bubbles, economic overheating, and a generalized inflation, all of which have strong associations with persistent, strong money growth. &nbsp; &nbsp;</p>
<p><b>Caveats &nbsp;&nbsp;<br>
</b>Though the change is noteworthy and should be watched, considerations on several levels leave room for skepticism about its staying power.&nbsp; One is statistical.&nbsp; Over this time of disappointing economic recovery, the money figures have shown other periods of acceleration that have then only petered out.&nbsp; Most recently 2012 saw such a false signal.&nbsp; During the summer and fall of that year, the M1 category of money jumped from the 6.5% average annualized rate of expansion it had averaged late in 2011 and earlier in 2012 to an annualized growth rate of almost 16%.&nbsp; But then it slowed again in early 2013.&nbsp; To be sure, this earlier money surge lacked the confirmation of a parallel acceleration in loan growth, such as exists today.&nbsp; Back then, overall bank lending grew at less than a 3.0% annualized rate.<sup>5</sup> The reinforcement offered by the loan data this time might make this latest flow seem more real and lasting, but still, the past false signal warns that things are not always what they seem and that it would be mistaken to take this latest evidence as an assured trend.</p>
<p>A certain wariness also lies behind the fact that most of what have been muted economic responses to date remain in place.&nbsp; Throughout this slow recovery, the bruising lessons of the 2008–09 financial crisis and recession have made banks and other financial institutions reluctant to lend, as they have made non-financial businesses reluctant to use credit.&nbsp; Perhaps, after more than five years, those bitter memories are beginning to fade.&nbsp; Of late, surveys of senior bank-lending officers suggest a slight easing in their willingness to lend.&nbsp; But it seems unlikely that such cautions will dissipate quickly.&nbsp; Meanwhile, the ambiguities and legal threats implicit in the massive and complex Dodd-Frank financial reform legislation remain an unchanged inducement to caution, as they have throughout.&nbsp; Also, little clarity has come to the Affordable Care Act.&nbsp; Its uncertainties and potential costs should continue to keep businesses and industry reticent about hiring and expansion and so reluctant to tap the otherwise plentiful and cheap flow of credit provided by the Fed to financial institutions and the financial system. &nbsp; &nbsp; &nbsp;</p>
<p><b>Conclusion<br>
</b>Against such a backdrop, investors and policymakers need to take a balanced view.&nbsp; On the surface, the accelerated flow of money should alert them to the possibility that the underlying financial and economic situation is changing, that at last liquidity is flowing into the economy; that in time it may have a reflection in an accelerated real growth path, with all the attendant improvements in profits and employment among other things; and that the Fed, to guard against the longer-term risks of a financial bubble and generalized inflationary pressure, will need to think about a gradual shift toward a less accommodative monetary stance.&nbsp; But the false signals of the past and the persistence of all the forces that have held back borrowing, lending, and growth signal that neither investors nor policymakers should take these preliminary signs as reason to change strategy yet, at least not radically.&nbsp; Ignoring them would be dangerous—but it would be equally dangerous to extrapolate them.&nbsp; Perhaps this is why Fed chairwoman Janet Yellen assiduously avoided reaching a conclusion during her recent testimony before Congress.</p>
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<p><span class="legal"><sup>1</sup>M1 consists of currency in the hands of the public, travelers’ checks, demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.<br>
</span><sup style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; line-height: 20px;">2</sup><span style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; font-size: 11px; line-height: 20px;">All data from the Federal Reserve.<br>
</span><sup style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; line-height: 20px;">3</sup><span style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; font-size: 11px; line-height: 20px;">Ibid.<br>
</span><sup style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; line-height: 20px;">4</sup><span style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; font-size: 11px; line-height: 20px;">Ibid.<br>
</span><sup style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; line-height: 20px;">5</sup><span style="color: rgb(102, 102, 102); font-family: Arial, Helvetica, sans-serif; font-size: 11px; line-height: 20px;">Ibid.</span></p>
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Tue, 18 Mar 2014 14:14:18 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-the-mild-kingdom.htmlU.S. Economy: The Mild Kingdom<div class="everything">
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<h3>&quot;Animal spirits&quot; remain caged as business spending lags. What will it take to unleash them?&nbsp;</h3>
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<p>The great economist John Maynard Keynes wisely noted that no economic stimulus could work unless it inspired the &quot;animal spirits&quot; of business. With this two-word phrase, he tried to sum up the optimism, the drive for expansion, the outright greed that prompts business managers, despite myriad unknowns, to hire, spend on new equipment and facilities, and engage in a host of expansion activities. Only when this happens can government stimulus spending or monetary ease prompt a generalized, self-sustaining expansion.</p>
<p>Cleary, the present recovery lacks for such &quot;spirits.&quot; Hiring remains less than lackluster by historical or just about any other standard. Spending on new structures by business has followed an uneven path at best. Spending on new equipment and systems offers a modestly brighter picture, but nothing like past recoveries. The word <i>spirited</i> hardly applies. What exactly has dampened the appetite for risk will, no doubt, offer much material for economic historians for many years to come. Surely part of the problem lies with the legacy of the financial crisis and the great recession. If anything can instill an excess of caution, an experience like that one can. Massive pieces of sweeping legislation, such as the Affordable Care Act and Dodd-Frank, whether good, bad, or indifferent as law, cannot help but engender uncertainty and further inspire excessive caution. Surely other, less prominent, influences have come into play.</p>
<p>This discussion leaves the post mortem to the historians. It aims instead to examine capital spending data in an effort to ascertain how this failure of spirit has manifested itself and whether there are signs of change. It arrives at two broad conclusions: 1) The contours of capital spending are generally much like other recoveries, just much more muted, a condition that looks likely to persist and 2) the industry-by-industry detail shows significant change in who is spending and on what—something that may require more of a policy response to remedy than Washington is capable of at the moment.</p>
<p><b>The Thirty Thousand-Foot View</b><br>
In this recovery, the broad aggregates have proceeded with much the same contours as in past recoveries. Typically, capital spending surges in the initial quarters of a cyclical rebound. Such surges have nothing to do with a need for new capacity. Coming off an economic trough, business and industry usually have ample spare capacity. Rather, these initial surges stem from the jump in profits that always accompanies the initial stages of recovery and that allows business to gratify the pent-up demand it postponed during the recession, usually for modernization, upgrading, and efficiency-enhancing equipment. Once this pent-up demand is gratified, such surges typically give away to a slower pace of expansion, as the pace of profits growth typically also slows from its own initial recovery surge. That period of slower expansion usually persists until later in the cycle, when increases in activity have finally employed existing productive capacities, at which time business again ramps up spending, this time on a broader basis to add to productive capacity generally.</p>
<p>This recovery has so far followed these general contours. In 2010 (the first full year of growth), for example, overall capital spending grew 8.1% in real terms, a little slower than the 9.0% average in comparable times in the previous five recoveries. The mix was true to historical form, too. Spending on equipment, innovation, and systems—what the Commerce Department refers to in part as &quot;intellectual property products&quot;—drove the bulk of this growth, expanding at almost a 9% rate in real terms. Spending on structures, not surprisingly after a generalized real estate collapse, continued to decline, by 2.9%, in real terms. In 2011–12, the declines in spending on structures turned into a modest expansion, but true to past cyclical patterns, spending on equipment and intellectual property slowed, growing at a much lower 6.3% annual pace, also slower than in past recoveries.<sup>1</sup></p>
<p>The pattern in 2013 also held true to this form. With business utilizing a still low 78.5% of existing capacity, the growth in outlays for capital equipment, intellectual products, and new structures continued to slow. Spending on structures grew barely over 1.0% in real terms, while spending on equipment and intellectual products expanded only 3.0% in real terms.<sup>2</sup> And because of the spirit-dampening weight on this recovery, this continued slowdown, though true to the general contours of past cyclical patterns, was considerably slower than the averages from those past cycles.</p>
<p>This pace will not likely pick up anytime soon. Perhaps distance from the pain of 2008–09 will allow the &quot;animal spirits&quot; of business to rise a bit, but otherwise all that has dampened that appetite for risk and expansion to date remains in place. More significantly, perhaps, rates of capacity utilization across industry will remain too low to spur a desire to increase productive capacity. Typically, this rate needs to climb above 82–83% to spur the second, later-cycle phase of rapid capital spending growth, and at likely rates of overall expansion, that point is still a long way off. Even in the unlikely event that the overall annual pace of real economic growth were to remain above 3.0% a year,<sup>3</sup> it would take until 2016 before capacity utilization would reach a point sufficient to prompt an acceleration in capital spending, and that is pushing the likelihoods on growth.</p>
<p><b>A Littler Closer to the Deck</b><br>
Taking the analysis down to a slightly lower elevation that can reveal greater detail, a marked difference from the past emerges, not only from past cycles but, pointedly, also from the trends that existed just before the financial crisis and the change in administrations in Washington. (Given common usage these days, the metaphor here should talk about &quot;drilling down&quot; instead of less elevation; but having started with an airplane metaphor, it seems only right to stick with it. Besides, the introduction of the word &quot;drilling&quot; immediately focuses minds on fracking, but that is only a part of this picture.)</p>
<p>The only industries that have accelerated their spending on structures from before the crisis are restaurants and bars, air transportation, special care medical facilities, and petroleum and gas drilling. The last, of course, reflects the fracking revolution, and will likely persist for some time. Spending by air transportation, no doubt, reflects the long neglected need to upgrade airport facilities and will run its course. The sudden spending on restaurants and bars inspires the imagination as to the whys, but without evidence, such speculation has no place here. The spending on special medical facilities, such as nursing homes, is no doubt an aspect of the well-established aging trend in the population and will likely also persist for some time. More interesting, and perhaps troubling, are the sectors that have shown dramatic spending decelerations. These include building for hospitals and most aspects of manufacturing. The former almost surely reflects a response to the constraints and uncertainties imposed by the Affordable Care Act. The latter reflects the caution implicit throughout this recovery. Neither looks likely to change anytime soon.</p>
<p>Where equipment and intellectual products are concerned, the picture hardly speaks to &quot;animal spirits&quot; either, and is even more problematic for the future. There, almost everything has slowed from before the crisis, even though this area has seen the fastest pace of growth so far in this recovery. The only exceptions are spending on cars, trucks of all kinds, and railroad equipment. The spending on railroad equipment may well have a connection to the fracking revolution, especially since regulatory considerations have impeded pipeline construction. For the rest, the problem is that much of this spending reflects a catch-up in areas long neglected. It will run its course, probably quite soon, and then no area of size will exhibit an acceleration from pre-crisis rates of expansion. It is particularly disappointing in this detail, especially in the quest for &quot;animal spirits,&quot; that real spending on custom software, research and development, and scientific effort in general have all shown a particularly marked slowdown, growing at a 5.8% annual rate so far in this recovery, compared with a 9.2% annual rate of advance during the three years prior to the crisis.<sup>4</sup></p>
<p><b>Prospects</b><br>
Combined, the picture suggests continued growth, but at a comparatively slow pace, as it has shown throughout this recovery. Especially from the configuration of detailed spending, it seems that the cautions and concerns that have weighed on this recovery will continue to do so. Sluggish hiring and restrained spending across the board indicate continued lingering fears from the financial crisis and great recession, while policy in Washington is hardly poised to lift the uncertainties that have dampened the verve of business for some time now. In the meantime, capacity utilization remains low enough to allow business to postpone any need for capacity expansion for a year more or longer. The &quot;animal spirits&quot; that Mr. Keynes identified as essential should remain subdued for the foreseeable future.</p>
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<p><span class="legal">* I would like to thank Steve Lipper, Lord Abbett Investment Strategist, for suggesting this line of analysis<br>
<sup>1</sup> All data from the Department of Commerce.<br>
<sup>2</sup> Ibid.<br>
<sup>3</sup> Ibid.<br>
<sup>4</sup> Ibid.</span></p>
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Mon, 10 Mar 2014 16:47:00 -0400http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/what-is-the-fed-thinking.htmlWhat Is the Fed Thinking?<div class="everything">
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<h3>The central bank's decision to taper, despite its earlier caution on the economy, has puzzled many observers. New research from the Fed's own staff may provide some clues to its current mindset.&nbsp;</h3>
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<p>It is becoming harder to divine the thinking of the Federal Reserve. Recent behavior—particularly the two moves to taper the amount of quantitative easing—seem out of character with the Fed's earlier, much more tentative tone, especially since little in the economy has changed, certainly not enough to explain or even warrant this this more aggressive turn. Meanwhile, Janet Yellen, the new Fed chairwoman, would seem likely to lean toward more caution, not less. While a definitive reason for the change in thinking will not likely emerge anytime soon, a piece of research from the Fed's own staff may provide a hint, for it calls into question the whole rationale for quantitative easing in the first place.&nbsp;</p>
<p><b>Seeming Change at the Fed</b><br>
There can be little doubt that the Fed’s tone has changed. Last spring, for example, then-Chairman Ben Bernanke announced that the Fed might begin cautiously to slow the flow of quantitative easing—&quot;taper,&quot; in his words. His language was very tentative, and he qualified the plan by saying that the economic circumstances had to be just-so for the Fed to go ahead. Markets reacted poorly, anyway. During June and July 2013, the yield on 10-year Treasury bonds jumped by almost 100 basis points (bps).<sup>1</sup> Stock indexes fell. But by August, markets had stabilized, and were ready for the Fed's active policy arm, the Federal Open Market Committee (FOMC), to start its taper when it met in September. But when the FOMC met, it decided to forgo even the first tentative steps toward the tapering. Consensus wisdom explained the caution in terms of Fed fears of renewed market turmoil or some underlying economic weakness about which only the Fed was aware, or a combination of the two.</p>
<p>Then, three months after this remarkable display of caution, the taper started. The FOMC announced in December 2013 its decision to buy $10 billion a month fewer Treasury and mortgage bonds than it had previously. Yet too little had changed in the economy to explain the move. There might have been slightly more optimism, but not the change for which the Fed said it was looking. The unemployment rate, for instance, had fallen slightly, but not because of new hiring; and anyway, it was still above the Fed's benchmark 6.5% of the workforce.<sup>2</sup> There was some uncertainty surrounding the change in leadership from Bernanke to Yellen, but in December, he still sat at the head of the table. Then in January 2014, barely four weeks from the first taper move, the FOMC announced another step to slow monthly bond purchases, again by another $10 billion. Not only was there no change in the underlying environment between December and January but also there was not even enough time to weigh the impact of the first taper.</p>
<p><b>New Research</b><br>
Only those on the FOMC, of course, can truly know the thought process behind this new eagerness to taper. But if the economic facts on the ground offer an insufficient explanation, a piece of Fed research might. Early last December, the FOMC received a remarkable study by two Fed economists, Steve A. Sharpe and Gustavo A. Suarez, titled, &quot;The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs.&quot; It concludes that companies are unlikely to cut back much on capital spending if interest rates rise, even by as much as 100 bps, and they are even less likely to expand such spending if interest rates were to fall, even by as much as 100 bps.<sup>3</sup> Since the whole point of quantitative easing was to stimulate business spending, and hence the economy, by reducing the cost of funds, the report must have given members of the FOMC pause. Certainly, it should have.</p>
<p>Of course, no single piece of research is ever conclusive. Still, this one is compelling, especially because it focuses on the period since the financial crisis and recession of 2008–09. Like all good scholars, Sharpe and Suarez's paper reviews earlier work in the field. It notes that these studies, which rely on time series data on interest rates and capital spending, find only a slight change in business behavior in response to interest rate moves. Other studies, which drill down to specific firms, find a slightly stronger relationship, but only slightly. Sharpe and Suarez's study approaches the matter differently from this earlier research. It relies on surveys, compiled by Duke University, of hundreds of CFOs in companies large and small across the country. These polls were made both before and after the rate increases in 2013.</p>
<p>If anything, Sharpe and Suarez find even less sensitivity to changes in yields and rates than did the earlier work. Only 8% of the respondents said they would increase this spending if the rates they face were to fall more by 100 bps and only 8% more said they would increase their spending if the rates were to fall in excess of 200 bps. Fully 68% said that they would not change the spending plans at all in response to interest rate moves, citing other factors, such as revenues growth and cash on hand, as more important. Rate increases drew only a slightly stronger response. Some 16% of the respondents said that they would reduce investment spending in response to a 100 basis-point rise in the rates they face, and another 15% said they would cut their spending for a rise of more than 200 bps—more sensitivity than they showed to rate declines, but still, hardly a powerful response.<sup>4</sup></p>
<p><b>Impact</b><br>
Since the main purpose of quantitative easing was to use rate and yield reductions to induce businesses to spend, and hence propel economic growth, these findings raise two significant policy doubts: 1) whether the Fed was right to initiate quantitative easing in the first place, and 2) whether a continuation of the program has promise of a favorable impact down the road. These results certainly strengthen the position of those on the FOMC who have doubted the program throughout. The Fed may be especially sensitive to these conclusions and the doubts they raise because it also is well aware that quantitative easing, whatever else it might do, carries considerable risk. Several members at the Fed, including Bernanke, have noted the possibility that quantitative easing could breed asset bubbles, such as developed from past, and less radical, easy monetary policies in the late 1990s and during the years 2005–07. Others have noted how excess flows of liquidity also led to generalized inflationary pressures, something the Fed definitely wants to avoid. Against such concerns, the research effectively warned the FOMC that its quantitative easing program was incurring risk with little or no chance of the reward policymakers sought.</p>
<p>No doubt, the report could not sway policy on its own. But given the tension over quantitative easing already in the FOMC and the clear longer-term risks of which all at the Fed are well aware, it may well have had an outsized impact and, so, go a long way to explaining the Fed's new eagerness to taper, even though little in the underlying economic fundamentals has changed since last year. It points, all else equal, to a measure of tapering at each FOMC meeting going forward.</p>
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<p><sup>1</sup> Data from Bloomberg.<br>
<sup>2</sup> Data from the Department of Labor.<br>
<sup>3</sup> Steve A. Sharpe and Gustavo A. Suarez, &quot;The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,&quot; Federal Reserve, December 2013.<br>
<sup>4</sup> Ibid.</p>
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Mon, 3 Mar 2014 21:52:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/us-economy-curb-your-enthusiasm.htmlU.S. Economy: Curb Your Enthusiasm<div class="everything">
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<h3>Amid optimistic projections of an acceleration in growth, the factors that have restrained GDP remain firmly in place.&nbsp;</h3>
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<p>A relatively strong end to 2013 seems to have generated talk of a generalized and sustained economic acceleration going forward. Journalists, tired of writing about slow growth, have embraced the new story line. The Federal Reserve and the International Monetary Fund (IMF) have raised their growth estimates for the U.S. economy in 2014 and 2015. Though a recovery doubtless will continue, the acceleration of which so many discuss will likely remain elusive. Never mind that these organizations have persistently shown overly optimistic projections—all that has kept growth slow to date remains in place.</p>
<p>No doubt the flow of statistics as the year progresses will change consensus opinion. It always does. In the final tally, a technical debate will ensue as to whether the forecasted acceleration was right or wrong. The pro and con of that dispute will, as always with economists, resemble the modern equivalent of medieval concerns over how many angels can dance on the head of a pin. To render the argument even sillier, it will revolve around statistics that will remain subject to revision for a long time to come. But as the following discussion of recent trends and their sustainability will show, the underlying picture, whatever the precise statistics that debaters reference, will remain one of continued, subpar economic recovery.</p>
<p>The root of all this recent enthusiasm is evident in the overall real gross domestic product (GDP) figures for the past year. The opening quarter of 2013 came in at a disappointing 1.1% real annualized growth rate, slow even by the standards of this disappointing recovery. At the time, the usual threats about a second recessionary dip gained currency and began to take over consensus thinking. The second quarter blunted some of this pessimism. It showed real growth up at a 2.5% annualized real rate, hardly good by the standards of past cyclical recoveries, but at least back on track with the rest of this disappointing recovery and enough to scotch talk of recession. The third quarter showed more strength, a 4.1% annualized rate of real growth. The preliminary 3.2% real growth figure for the fourth quarter seemed to confirm, at least for some, that something good was happening.<sup>1</sup> Though even these figures look slow by the standards of past recoveries, they were enough to change the tone of consensus chatter. Recent weaker numbers already have taken some of the bloom of the rose of growth enthusiasm.</p>
<p><b>A Question of Inventories</b><br>
Inventory patterns always presented a reason to doubt expectations of robust growth. A remarkable amount of the second half acceleration reflected an accumulation of goods on shop shelves and in warehouses across the country. According to the current state of statistics offered by the Commerce Department, this accumulation alone accounted for a little less than a third of the second half growth and almost two-thirds of the acceleration over the first half of the year. But though the Commerce Department reasonably counts inventories in the GDP because the economy produced them, they remain unsold. Actual final sales to final users in the second half grew much less robustly, at a 2.6% average annualized rate, up, admittedly, from the 2.3% annualized rate of the first half, but hardly the picture of a marked pick up that emerges when inventory accumulations are included, as they are in the headline figures.<sup>2</sup></p>
<p>There is something else about this inventory buildup. Going forward, business is likely to meet future sales with these accumulated stocks of goods instead of with new production, or at least it will meet some of those sales in this way. Because a depletion of inventories would count against the gross growth figure, that measure would then trail the pace of final sales. To be sure, inventory sales ratios are up only slightly, and so invite only a small adjustment. Auto inventories today, for instance, stand at almost 2.2 months' sales, up from just over 2.0 a year ago. Overall retail inventories, presently at almost 1.5 months of sales, are less than 3.0% higher than they were a year ago. It is, however, far from a huge overhang. But it could convince management to trim inventory stocks a bit and certainly not to add much more to them. Either way, the figures going forward would miss the inventory fillip they got during 2013's second half. At best, the overall real GDP record would just about track the ongoing slow pace of final sales, at about a 2.5% annualized rate.<sup>3</sup></p>
<p><b>The Household Sector</b><br>
Consumer spending did accelerate in the fourth quarter, at least according to the Commerce Department's preliminary figures. Its overall annual rate of real growth registered 3.3%, compared with an average annual growth rate of 2.0% for the first three quarters of the year. Spending on housing buoyed the third quarter especially, expanding in real terms at a 10.3% annualized growth rate.<sup>4</sup> But three factors call into question the sustainability of both those contributions to overall real GDP growth, at least at the pace of last year's second half. One is still weak labor markets and the implications that they have for income growth. The second is the already evident slowdown in home sales and construction. And the third is the mix of the recent spending surge.</p>
<p>Hiring remains lackluster. Some months show better payroll growth than others, contributing to alternating bouts of optimism and pessimism, but the underlying trend can at best be described as sluggish. During the past 18 months, payrolls averaged a monthly rise of 181,000, far slower than in past recoveries. During the last six months, the average actually slowed to 170,000 a month. At the same time, the average weekly wage has increased at a paltry 1.5% annual rate. This wage figure would have shown even slower growth were it not that industry turned to overtime in place of hiring. The resulting combination of employment and wage growth is sufficient to propel modest growth in consumption, but not enough to sustain the strong pace registered during fourth quarter 2013 especially. As it is, households, to support that expansion in consumption, had to slow their pace of savings, from 4.9% of their aftertax income last summer to 4.3%.<sup>5</sup> Even if households are willing to renounce the embrace of thrift they made after the 2008–09 recession and financial crisis, there are limits to how far this can go.</p>
<p>Meanwhile, the housing recovery, which had gained such striking momentum earlier in 2013, has begun to slow. Its earlier powerful pace was never sustainable. Lenders have remained reluctant to extend credit, and besides, the recorded surge was more a typical statistical bounce from a very low trough than anything fundamental. It is noteworthy in this regard that the power of the initial surge occurred almost exclusively in those regions of the country where the previous downdrafts were most severe—Southern California, Nevada, Arizona, and Florida. The rise in mortgage rates during summer, after the Fed announced its decision to taper its rate of quantitative easing, reinforced a slowdown that was otherwise built into the fundamentals. Actually, sales and construction fell some during the later months of 2013. The sector will likely return to growth. Residential real estate remains historically affordable, even with the rise in home prices earlier in the year and the more recent rise in mortgage rates. And lenders are becoming a little easier about extending credit for home purchases. But the sector will not likely return to the rapid growth pace of earlier in 2013.<sup>6</sup></p>
<p>And then there is the mix of spending during the surge. Three areas showed the greatest sales growth—autos, home furnishings and appliances, and recreational goods and vehicles, each expanding in real terms at annualized rates of, respectively, 3.0%, 9.6%, and 10%. Certainly, the slowdown in housing sales and construction should slow the pace of spending on home furnishings and appliances going forward. But more than that, all these sorts of purchases are durable goods. For most people, they constitute a one-time purchase that is not repeated for years. This recent surge reflected a measure of confidence that allowed consumers to catch up with long-deferred purchases. The average age of the country's auto fleet had reached the point where some large measure of replacement was all but inevitable. Perhaps that effect will carry on a little longer, but, by its nature, it cannot persist for long. As with other sources of this surge, its strength will likely fade, even as some moderate growth continues. The seemingly sudden 0.4% decline in retail sales recorded for January<sup>7</sup> would seem to confirm this slowing picture, but, of course, the weather-induced severity of the adjustment overstates the degree of weakness.</p>
<p><b>Capital Investment and Trade</b><br>
Capital investment by business and industry was only a small part of the second half GDP surge. There was only a slight acceleration in real spending on equipment, from a 2.5% real annualized rate of gain in the first half to a 3.1% rate in the second half. Real spending on what the Commerce Department calls &quot;intellectual property&quot; accelerated more, from a real 1.1% annualized rate of advance in the first half to a 4.5% rate in the second half. Meanwhile, real spending on structures and other fixed facilities followed its typical lumpy pattern, falling in real terms at a 25.7% annual rate in the first quarter, rising at a 17.6% rate in the second and at a 13.4% rate in the third, only to fall at almost a 10.0% annualized rate in the last quarter, at least according to preliminary figures. All this spending on average contributed a bit over half a percentage point to overall real GDP growth.<sup>8</sup> Though there is every reason to expect this to continue, the caution continuously shown by business for years now, in its expansion plans, its hiring, even in its acquisitions, makes it doubtful that such spending will surge at all, much less enough to change the overall economic picture.</p>
<p>Trade is very different. Both a rise in exports and a fall in imports contributed greatly to the GDP acceleration during 2013's second half. Real exports accelerated from a 3.4% real annualized rate of growth during the year's first half to a 7.6% rate during the second half. Real imports, which count as a negative in the Commerce Department's GDP calculation, slowed from a 3.8% annualized rate of real growth in the first half to only a 1.7% rate in the second half. Combined, the contribution of net trade to real GDP growth swung from a 0.2 percentage-point <i>detraction</i> in the first half to more than a 0.7 percentage-point <i>contribution</i> in the second, a swing of almost a full percentage point.<sup>9</sup> Because so much of this improvement reflects the fracking revolution in the energy industry, which is still gaining momentum, there is reason to expect the positive effects to persist into 2014 and 2015 and beyond, if not quite at the recent pace, at a significant pace nonetheless.</p>
<p><b>Government</b><br>
This area, which detracted from growth all last year, should offer a modest contribution over the next 12–24 months. Actually, state and local government spending had begun to pick up a small measure of momentum last spring. Tax revenues have at last begun to pick up—not enough, of course, to put state and local government finances in good shape, but enough to turn the picture from one of cutbacks to one of modest re-hiring and modest increases in spending on other obligations. It was not a big deal. Such outlays in real terms went from declines of about 1.0% at an annual rate in 2012's last quarter and 1.3% in 2013's first quarter to a growth of about 1.3% in 2013's second half.<sup>10</sup> Hardly the stuff of a boom, but an improvement nonetheless and one that shows every indication of persisting.</p>
<p>The federal picture should turn around more dramatically. Spending on goods and services, for defense and non-defense purposes, the only part that counts in the GDP, fell consistently throughout 2013, at a 5.0% annual rate in real terms during the first half of the year and at a 7.1% rate on the second half. But as the recent budget deal has postponed any sequester effects for a couple of years, the declines of last year should turn to modest increases this year, perhaps as much as 2.0–2.5% in real terms. So whereas federal cutbacks detracted some 0.4 percentage points from overall real GDP growth last year, they may add slightly, perhaps 0.2 percentage points, to growth during 2014.<sup>11</sup> That change constitutes a swing of more than half a percentage point—not enough to drive a substantive acceleration, but a contribution to the overall growth picture, nonetheless.</p>
<p><b>Pulling the Threads Together</b><br>
Though the picture in trade and government would suggest some real growth acceleration, these are hardly enough to overwhelm the larger areas expected to slow. Capital spending, after all, will likely track a still modest growth path and consumer spending going forward will, as explained, likely grow at a slower pace than in last year's second half. Since the consumer constitutes some 70% of the economy, even a modest slowdown in the sector can offset the aggregate effect of modest accelerations elsewhere. Meanwhile, housing, though it will likely resume its recovery in 2014, will expand at nowhere near the speed of 2013. The inventory effect will almost surely slow the aggregate growth pace. The balance is a continued slow recovery along the lines to which all have grown accustomed over these last few years, even if the exact contours of the mix clearly will change.</p>
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<p><span class="legal"><sup>1</sup> All data from the Department of Commerce.<br>
<sup>2</sup> Ibid.<br>
<sup>3</sup> Ibid.<br>
<sup>4</sup> Ibid.<br>
<sup>5</sup> Ibid.<br>
<sup>6</sup> S&amp;P/Case-Shiller data.<br>
<sup>7</sup> All data from the Department of Commerce.<br>
<sup>8</sup> Ibid.<br>
<sup>9</sup> Ibid.<br>
<sup>10</sup> Ibid.<br>
<sup>11</sup> Ibid.</span><br>
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Mon, 24 Feb 2014 16:33:08 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-fed-yellen-staperingtightrope.htmlThe Fed: Yellen's Tapering Tightrope<div class="everything">
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<h3>In reducing quantitative easing, the Federal Reserve chairwoman faces a big challenge: preventing asset bubbles at home without pressuring developing economies.&nbsp;</h3>
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<p>Like a tightrope walker, Federal Reserve chairwoman Janet Yellen and her colleagues at the Fed dare not lean too far in one direction of monetary policy or another. On the one side, they know that they have to taper their quantitative easing program and generally rein in the Fed's present, extremely easy monetary posture. As former chairman Ben Bernanke has repeatedly made clear, a failure to do so risks financial bubbles and, worse, a generalized inflation. But on the other side, the still fragile state of global finance and economics creates a vulnerability to even minor policy adjustments. The recent turmoil in emerging markets testifies to this risk. It is surely too early to judge whether either danger will become a reality or, if so, which one, but investors, nonetheless, need to keep a weather eye on both sides of this risk equation.</p>
<p><b>Ominous Precedents</b><br>
Recent history speaks loudly to these risks, the second one in particular. The last two collapses in markets and the economy—2000–01 and 2008–09—resulted from Fed tightening that otherwise seemed minor, but nonetheless had an outsized impact on markets and through them on economic activity.</p>
<p>The first of these developed less from active Fed policy than from Fed neglect, but ultimately owed much to this kind of a policy error. The problem began in China. Because this country had set out to promote its exports by keeping down the foreign exchange value of its currency, the yuan, the People's Bank of China had to buy dollars almost continually, which it then invested largely in U.S. government securities. This flood of liquidity into U.S. financial markets helped inflate the dot-com and technology bubble that expanded throughout much of the 1990s. The Fed could have neutralized, that is &quot;sterilized,&quot; the effect of these Chinese flows, but for reasons of its own, the Fed chose not to do so. It burst the bubble it had allowed Chinese liquidity to create, on its own. And it did so inadvertently. Worried in 1999 about a modest uptick in inflation, policymakers engineered what must have seemed to the Fed very moderate restraint. Short-term interest rates rose by a mere 80 basis points over the course of that year, not even back to the levels that had prevailed earlier in 1998. But markets, already bloated with excess liquidity, had an outsized reaction. The technology and dot-com collapse of 2000–01 followed.<sup>1</sup></p>
<p>The second bubble and bust was even more closely related to Fed policy. Of course, Chinese liquidity continued to flow into the United States during the early years of this century, as it still does. This time, the Fed's easing efforts to promote recovery after the technology/dot-com bust actually added to the flood. The investment focus settled on real estate instead of a particular sector of the stock market, but, as previously, the country was experiencing a liquidity-driven rise in asset prices beyond what any economic fundamentals warranted. When the Fed, mildly worried in 2006 and 2007 over economic overheating and a slight acceleration in the pace of inflation, decided to drain a small measure of liquidity from markets again accustomed to a flood of liquidity, the markets reacted radically, even more violently than in 2000. The resulting economic and financial carnage is familiar to all.<sup>2</sup></p>
<p><b>Risk of a Repeat?</b><br>
Now, as the Fed continues to taper its quantitative easing, the obvious question to ask is whether there is a risk that this pattern of bubble and burst will repeat. The short answer is, yes, the risk exists. Markets for years now, since 2008 in fact, have seen a flood of Fed-provided liquidity, and asset prices have risen in part because of it. What in any other circumstance would look like the most modest of policy adjustments could create an outsized reaction. But if the risk of a repeat exists, much evidence suggests that it is not a probability.</p>
<p>On the worrisome side is the recent behavior of risk assets, particularly in emerging markets. From the moment last spring that the Fed first began to talk about tapering, emerging market currencies, bonds, and equities have all suffered and in much the same way as when past bubbles have burst. Between June and September last year, emerging market equities, as a group, lost about 13% of their value,<sup>3</sup> even as many of their currencies also suffered setbacks and the rates they had to pay to borrow rose. When the Fed forewent a tapering move last September, these equity markets recovered some of the ground they had lost, but they gave it all back and more when the Fed actually began to taper in December 2013 and January 2014. Meanwhile, currency pressure in several of those countries reached crisis levels, and the rates markets charged them to borrow rose still more, whether the debt was denominated in dollars or in their own currencies.</p>
<p>As familiar as the pattern looks on the surface, however, several differences from the past push the probabilities away from a repeat of such disasters. For one, the Fed's actions to date hardly constitute even modest monetary restraint. Policymakers, after all, have only slowed the pace at which they are pouring new liquidity into markets. Up until last December, the Fed was buying $85 billion a month of Treasury and mortgage-backed bonds. The Fed has slowed down the flow to $65 billion a month.<sup>4</sup> This is hardly a withdrawal of liquidity. Indeed, it still constitutes a torrent of monetary support. Meanwhile, the Fed has kept short-term interest rates near zero, another major support to the markets. Nor are markets as overpriced as they were in 2000 or 2008. The rallies of the past few years have realized much of the superb valuations that had existed, but in no way are either equity or real estate prices as far from the economic fundamentals as they were in past bubbles.</p>
<p><b>The Balance of Evidence</b><br>
To be sure, people in the past seemed unaware of how out of line prices had become, and the Fed thought it was following a moderate path. It also is true that emerging markets concerns today go beyond liquidity. Argentina, for example, suffers from an unsupportable debt overhang and Turkey from political discord troubles. Questions have arisen about the sustainability of China’s growth rate and its debt overhang. But if this emerging market response is not quite yet the proverbial canary in the coal mine alerting to a danger, it is reminiscent of past blunders and it is a cautionary flag that investors need to acknowledge, even if the entire economic picture still says they may never have to heed it.</p>
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<p><sup>1</sup> For more detail, see, Milton Ezrati, <i>Thirty Tomorrows</i> (New York: Thomas Dunn Books/St. Martin's Press; forthcoming April 2014), especially chapter 13.<br>
<sup>2</sup> Ibid.<br>
<sup>3</sup> Data from Bloomberg.<br>
<sup>4</sup> Data from the Federal Reserve.</p>
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Tue, 18 Feb 2014 09:28:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/labor-do-the-jobless-lack-the-skills.htmlLabor: Do the Jobless Lack the Skills? <div class="everything">
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<h3>Many commentators worry that a skills mismatch is weighing on the U.S. labor market. But the elevated unemployment rate stems from a variety of other factors</h3>
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<p>The answer to the title question is: No, probably not. It is, of course, very popular to explain the nation's stubbornly high unemployment in terms of a mismatch between the skills the economy needs and those that exist in the workforce. People of all political stripes—in Washington, in business, academia, think tanks, even organized labor—have done so and have proposed solutions, usually, and not coincidentally, furthering their partisan agendas. To be sure, this consensus is broadly correct. The modern developed economy will need ever better educated, better trained workers. But though an important longer-term issue, today's stubbornly high rate of unemployment seems to result from more cyclical and immediate policy considerations, such as extreme caution in corporate America, skewed wage expectations, and the extension of unemployment benefits. The skills mismatch may in time create chronically higher unemployment, but that is not what is happening now.</p>
<p><b>A Popular Argument Indeed</b><br>
The popularity of the skills mismatch argument is evident. President Obama noted the issue in the last three State of the Union addresses, and in his latest budget asked for $8 billion in new monies for training to address it. His opponent in the 2012 election, Mitt Romney, while disagreeing on almost every other point with the president, asserted that a skills mismatch &quot;lies at the heart of our job crisis.&quot; The president of the Minneapolis Federal Reserve has pointed to the skills gap as the root of the nation's unemployment problem,<sup>1</sup> as has the U.S. Chamber of Commerce. The International Labor Organization, in its publication <i>Global Employment Trend 2013</i>, features the mismatch as the cause of &quot;long-term unemployment,&quot;<sup>2</sup> while the prestigious Organization for Economic Cooperation and Development (OECD) has produced book-length studies documenting the mismatch in the United States and across its global membership. And those are only some of the most prominent sources of such commentary.</p>
<p>It is easy enough to understand why so many people and interests seek an explanation. The nation's labor market has behaved in an atypical way. Usually, unemployment rises when there is a shortage of jobs on offer and falls when business and government put more jobs on the market. But since this recovery began in 2009, the United States, and many other developed countries as well, have suffered abnormally high rates of unemployment even as the number of available job openings has increased. It is unusual and disturbing that people go wanting for jobs at the same time as jobs go begging people to fill them. Yet as millions have failed to find work, so much so, in fact, that millions have even given up trying: the number of unfilled positions offered by business and industry has risen by almost 1.5 million, from about 1.4% of the total to about 2.4%, some 600,000 of these positions in manufacturing.<sup>3</sup> This strange twist in the Beveridge curve (what economists call the graphic presentation of this relationship) naturally makes all concerned look to explanations outside the normal business cycle, and the existence of a skills mismatch naturally attracts.</p>
<p><b>Reason to Look Elsewhere</b><br>
Aside from such atypical statistical relationships, the main support for the skills mismatch explanation comes from research that found rapid wage increases in some skills and stagnation in others. Those conducting the research allow that the situation could reflect a particular need rather than the general skills mismatch of which most commentary speak. But it does point in that direction.</p>
<p>Other than this, however, most other investigations raise a measure of skepticism about the skills mismatch explanation, and point to other causes. Studies that examine specific jobs and the men and women who hold them find no evidence of a skills mismatch at all, except perhaps for high school dropouts. The Chicago Federal Reserve Bank, in its review of work done elsewhere as well as its own original research, offers more reason to doubt the skills mismatch. The bank points to the considerable evidence that firms have approached recruiting less aggressively than they have in the past. It reviews other research questioning the skills mismatch explanation by pointing out how little variation there is from one industry to another. All show employment below past peaks, high- and low-skill industries and positions alike. The Chicago Fed's own work raises a similar point. If the problem were a general skills shortfall, one would think the mismatch would occur in particular sectors, levels of skill, and industries.</p>
<p>Some of the most interesting work on this question comes out of Northeastern University. There, Professor William Dickens compared job openings statistics to unemployment data disaggregated according to the duration of unemployment.<sup>4</sup> In this way, he composed a series of what could be described as specialized Beveridge curves for each subgroup. Dickens discovered no relationship at all between short-term unemployment (five weeks or less) and job vacancies. The implication is that such unemployment, as in the past, simply reflects the normal hiatus people face when they change jobs, even when the move is planned, what economists call frictional unemployment. When he did a similar analysis for those unemployed for five to 14 weeks and 15–26 weeks, he discovered that in the conventional relationship between jobs on offer and unemployment, the more jobs there are available, the less unemployment there is. Only for the very long-term unemployed (27 weeks or more) did he observe the strange result in which the number of jobs on offer and unemployment rose in tandem. It seems, then, that the entire departure from past cycles is concentrated in this group of long-term unemployed.</p>
<p><b>Drawing the Pieces Together</b><br>
It is possible, of course, that a skills mismatch creates the long-term unemployment. No doubt, there is something to this. But in light of all this research, it would seem that other causes lie at the root of this stubbornly high long-term unemployment. Extreme caution among managements is entirely plausible given the severity of the past recession and the uncertainties imposed by the Affordable Care Act and other massive pieces of legislation. In addition, the 2008–09 recession created layoffs in areas where pay was high relative to skill levels, finance, construction, real estate sales, and media, in particular. As these people have sought alternative employment, they have no doubt balked at the lower salaries they have been offered and, quite naturally, have held back in the hopes of finding jobs in which they could recover a greater share of their former wage or salary. At the same time, such behavior has received encouragement from a third factor, the government's decision to greatly elongate the period over which people could collect unemployment.<sup>5</sup></p>
<p>If this analysis is correct, and it seems likely, this strong relationship will break down in time, quite aside from any efforts to erase a skills mismatch. Time, of course, will clarify the uncertainties still surrounding the ambitious legislation of the past few years. It also will heal the wounds left on management by the last severe downturn in 2008–09. Time also will convince many that their former wages and salaries cannot in fact be reproduced, forcing the unemployed to accept less than they commanded during the artificial environment of the last boom. The recent decision to remove the prop of exceptionally long-term unemployment benefits should accelerate this process. It will impose hardship, to be sure, and no one wants to see that. But it also will spur these long-term unemployed to accept positions, disappointing as the wages are, even if only as an interim solution, and, accordingly, reduce the number of the long-term unemployed.</p>
<p>Over the longer term, perhaps, a skills mismatch, and an education mismatch, which is different, could cause a chronically elevated unemployment rate. Indeed, such a prospect would be likely, if the nation fails to give greater attention to training, education, and also immigration reform. But it would be premature to look for such a result until—or if—the economy fails to step up to the needs of the more demanding future economy. For now, the data cannot support the skills mismatch argument as a cause of stubbornly high unemployment, no matter how popular it is.</p>
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<p><sup>1</sup> Federal Reserve.<br>
<sup>2</sup> International Labor Organization, February 4, 2013, and Barbara Kiviat, &quot;The Big Jobs Myth,&quot; <i>The Atlantic</i>, July 2012.<br>
<sup>3</sup> All data from the Department of Labor.<br>
<sup>4</sup> Jason Faberman and Bhashkar Mazumder, &quot;Is There a Skills Mismatch in the Labor Market?&quot; <i>Chicago Fed Letter</i>, July 2012.<br>
<sup>5</sup> For more detail, see Rand Ghayad and William Dickens, &quot;It's Not a Skill Mismatch,&quot; <i>VOX Policy Analysis</i>, January 5, 2013.</p>
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Mon, 10 Feb 2014 11:31:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/hows-housing-doing.htmlHow's Housing Doing? <div class="everything">
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<h3>The residential real estate market should continue its modest improvement in 2014-15—with positive implications for the U.S. economic recovery.</h3>
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<p>Beneath its typically erratic month-to-month pattern, the housing recovery has slowed. Some of this was bound to happen. The sharp rebound registered earlier last year was hardly sustainable. Because the Federal Reserve's talk of tapering raised mortgage rates last summer, the inevitable slowdown in the pace of recovery turned to a modest decline. But for all this, moderate continued improvements in residential real estate look reasonably secure in 2014-15, and with it greater security for a continuation of the admittedly slow economic recovery overall.</p>
<p><b>The Picture So Far</b><br>
During the first half of 2013, housing appeared to be roaring back. Sales of existing homes—all those properties that had been languishing behind the for-sale signs for years—jumped at a 17.7 % annual rate between January and July. Sales of new homes followed a more erratic pattern, but rose at a 29% annual rate on balance during the first six months of the year.<sup>1</sup> Real estate prices increased in response to the renewed demand. According to the National Association of Realtors, the median sales price of a home rose nationally at a 41% annual rate between January and June.<sup>2</sup> A different price measure, the S&amp;P/Case-Shiller Home Price Index,<sup>3</sup> rose at a 19.1% annual rate during this same time.<sup>4</sup></p>
<p>This kind of a surge was unsurprising, but always unsustainable. Given the depths to which residential real estate had sunk, a strong initial bounce was typical. But such surges also typically tend to run their course quickly. The signs were all there. The greatest gains occurred in Florida, Nevada, Arizona, and California—the states that had seen the worst downdrafts. Elsewhere in the country, the gains were much more moderate. Meanwhile in June and July, bond yields and mortgage rates jumped in response to talk from the Fed about tapering the flow of new liquidity in its quantitative easing program. The average mortgage rate offered by lenders rose more than 100 basis points (bps) between June and September, all but ensuring a more pronounced slowdown in the pace of recovery, more, in fact, than was already built into the market dynamic.</p>
<p>Accordingly, between July and year-end, it began to look as though the housing market had relapsed into decline. Sales of existing homes fell at a 15.1% annual rate from July through November (the most recent month for which data) fell at a 15.4% annual rate between June and December.<sup>5</sup> Median sales prices for existing homes, as tracked by the National Association of Realtors, slipped at a 15.9% annual rate during this time,<sup>6</sup> while the S&amp;P/Case-Shiller Price Index showed gains at an 8.1% annual rate between June and November (the most recent period for which these data are available),<sup>7</sup> still strongly positive, but slower than earlier in the year.</p>
<p><b>Now What?</b><br>
The natural question now is to ask whether the housing recovery can regain traction in 2014 and 2015. The probabilities indicate that, yes it can and will, but at a much slower pace than averaged early last year. Though Fed policy will edge up mortgage rates, affordability remains high, and lenders will likely become less reluctant to extend credit to residential real estate.</p>
<p>Housing remains remarkably affordable, at least by historical standards. To be sure, it is down from where it was between 2009 and 2012, or earlier in 2013. Real estate prices, up on balance nearly 10% during the last 12 months, have outpaced the growth of median household income, up only 2.1% during this time, and mortgage rates have gone up by 125 bps. The burden of servicing a mortgage on the median property has gone from 12.3% of median family incomes a year ago to 14.7% last November (the most recent period for which data are available). Taking all this into consideration, the National Association of Realtors estimates that, nationally, a home is 16.1% less affordable than it was a year ago. On this basis, it would be reasonable to look for a slowdown in the pace of recovery, but since even today’s reduced affordability is better than any time in the past 40 years (except for the past four years), it also is reasonable to expect a recovery to continue.<sup>8</sup></p>
<p>Affordability will probably lose still more ground over the course of the next 12–18 months. Though household incomes will undoubtedly rise, any gains will run only slightly faster than last year at best. Constrained employment growth will hold back the pace of any gains, as will the retarding effect on wages of still-high rates of unemployment. Though housing price gains also should slow, they nonetheless will likely outpace income growth. And, of course, continued Fed tapering will raise mortgage rates, perhaps by another 100 bps over the next 12 months. On this basis, affordability may well deteriorate by another 10–15%. But even with such further deterioration, affordability will remain almost 30% better than its best levels of the 1980s, 1990s, and earlier years of this century, again excluding the last four years.</p>
<p>The recovery could get some small extra momentum in 2014–15 as lending institutions become modestly easier about extending credit in real estate. After the 2008–09 financial crisis, most lenders, understandably, wanted nothing to do with real estate. According to the Fed, they cut back on their lending in the area by 5–6% a year in 2009 and 2010, and by about 2.4% a year on average in 2011 and 2012. Even early last year, as the housing recovery gained momentum, banks cut their mortgage exposure by 1.2%. This reluctance to lend has kept many buyers from taking advantage of the historical affordability that developed during this time. But December showed the first modest rise in real estate lending, albeit only at a 2.4% annual rate. This new willingness to extend credit to the area seems to have extended into January, on admittedly very preliminary data. If the availability of credit continues to improve, the recovery will receive help, especially since housing will remain historically affordable, if not quite as affordable as it was last year. Still, given the remembered pain of 2008-09, it is unlikely that lenders will change their attitudes fast enough or far enough to change the expected slow recovery into something substantively more robust.<sup>9</sup></p>
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<p><sup>1</sup> Data from the Department of Commerce.<br>
<sup>2</sup> Data from the National Association of Realtors.<br>
<sup>3</sup> The S&amp;P/Case-Shiller 20-City Home Price Index measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan regions across the United States.<br>
<sup>4</sup> Data from Standard &amp; Poor's.<br>
<sup>5</sup> Data from the Department of Commerce.<br>
<sup>6</sup> Data from the National Association of Realtors.<br>
<sup>7</sup> Data from Standard &amp; Poor's.<br>
<sup>8</sup> All data from the National Association of Realtors.<br>
<sup>9</sup> All data from the Federal Reserve.</p>
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Mon, 3 Feb 2014 10:26:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-future-in-focus-trade-could-aid-an-aging-america.htmlThe Future in Focus: Trade Could Aid an Aging America <div class="everything">
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<h3>Goods and services sourced from overseas could help the United States alleviate the effects of future labor shortages—if lawmakers can resist protectionist impulses.</h3>
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<p>This is the fifth and last in a series on the aging trend of this country's population and its financial and economic ramifications. The first in this series, which appeared on November 25, 2013, explained how increasing longevity and low birth rates will create an ever larger overhang of dependent retirees and a relative shortage of working-age people. The second and third numbers in this series examined sources of relief from the adverse implications for pension funding and economic growth implicit in these demographic imperatives—increases in productivity, greater rates of workforce participation, heightened levels of immigration, and, most effective of all, increases in international trade and globalization. The fourth number in this series took up the economic adjustments needed to support such remedies. This last essay takes up the challenges facing this country's leadership in its effort to protect the crucial trade remedy against protectionism.</p>
<p><b>Protectionism Is Gaining Popularity</b><br>
The protectionist challenge is evident. The push for tariffs and other means to restrain trade has intensified in the United States and across the world. It would be a dangerous trend under any circumstance, for little in economic history is so clear as the ill effects of protectionist policies. But the danger is that much greater now, given the need (described earlier in this series) for increased trade as a means to relieve demographic strains.</p>
<p>To be sure, the growing protectionist sentiment is understandable. The once great promise of globalization has shown a dark side that has turned a once enthusiast public into one skeptical at best and, in many cases, openly hostile. Firms have closed or moved abroad, and people have lost their jobs, most especially in the simpler, labor-intensive industries, such as textiles, toy manufacture, call centers, assemblies of every kind—from cars to computers—the kinds of effort where the low wages of the emerging economies offer either an irresistible competition or an irresistible temptation to outsource or offshore. Because the domestic losses have occurred in lower-wage areas, globalization has taken much of the blame for the growing and troubling gap between rich and poor in the United States. The attendant public sympathy has inevitably inspired political rhetoric and action, much with no thought to unintended consequences.<sup>1</sup></p>
<p>It would take pages to itemize every example of protectionist rhetoric and policy to emerge in the United States lately, much less across the globe. Even a summary makes an unwieldy list, though perhaps just a few examples can suffice. It was noteworthy, for instance, how during the 2008 Democratic primaries, Hillary Clinton and Barack Obama competed actively for which candidates could talk &quot;tougher&quot; on trade. Obama actually elicited complaints from Canada and Mexico by pledging to renegotiate the North American Free Trade Agreement (NAFTA), while Clinton called for a &quot;time out&quot; on new trade deals.<sup>2</sup> Nor is the protectionist sentiment reserved for Democrats. Surveys of elected Republicans show strong skepticism about the benefits of free trade.<sup>3</sup> Senators Chuck Schumer (D-NY) and Lindsey Graham (R-SC) make an unlikely pair, but more than once they have joined to call for high tariffs on Chinese imports to punish Beijing for what they believe is a form of Chinese protectionism. Their proposal once got the backing of 67 out of 100 senators.<sup>4</sup> Nor is this sentiment exclusive to the United States. The World Trade Organization's (WTO) so-called Doha Round of trade liberalization negotiations has all but failed. Protectionist policies have gained currency across Europe, in China, and elsewhere.<sup>5</sup></p>
<p>Protectionist policies and proposals come in a variety of shapes and sizes. They include tariffs, subsidies, buy-local rules, restrictions on borrowing and lending, environmental and labor rules, and agricultural supports. They all aim, however, to do one thing: block international trade and money flows.<sup>6</sup> They are dangerous in whatever form they take. Clearly, any such restrictions, by cutting the country off from foreign product, will (as earlier numbers in this series noted) prevent a nation from relieving the strains of an aging population through access to the output of foreign labor. But even were the country not under this particular demographic pressure, history shows that trade restrictions would do plenty of harm anyway.</p>
<p>At the very least, they would raise the cost of living for the average American. The only reason imports are a threat is because they cost less than the domestic equivalent. By cutting off this flow of inexpensive product to the population at large, protectionists effectively would reduce the real buying power of American incomes. Analysis shows that trade has at times held back increases in the general cost of living by two or more percentage points in a year.<sup>7</sup> It may seem a small price to pay to save jobs. After all, the hardship to consumers is diffused through the general population, while the pain of those losing jobs to imports is acute. No doubt such differences in intensity explain why politicians and public sympathy find protectionism so tempting. But once protectionist policies are implemented, the loss of these general benefits would become painfully obvious, as it has in the past, along with other ill effects. Probably the ultimate example lies in the history of the Smoot-Hawley Tariffs imposed during the Great Depression.</p>
<p>After the stock market crash of 1929, Senator Reid Smoot (R-UT) and Representative Willis Hawley (R-OR) set out to save American jobs by keeping out imports. They raised tariffs on 20,000 items by an average of 20%.<sup>8</sup> The legislation hurt immediately by keeping out lower-cost goods and consequently raising the living expenses of an otherwise beleaguered working population. The resulting retaliations compounded the economic harm. International commentary at the time identified this legislation as cause of an &quot;outburst of tariff making.&quot;<sup>9</sup> Ultimately, world trade fell 67%. The United States, which in those days was an export-dependent economy, saw its exports fall 75%, even as its imports fell 40%.<sup>10</sup> There is some dispute among professional economists whether Smoot-Hawley turned a deep recession into the Great Depression, but all agree it contributed mightily to the misery. There is even evidence that the legislation cut off a nascent recovery. Business in early 1930 seemed to be recovering from the effects of the 1929 market crash. Unemployment had fallen, from 9% in January of that year to 6.3% by June. After President Herbert Hoover signed the tariffs into law on June 17, 1930, however, the gains reversed. The stock market anticipated the ill effects, declining 10% on the afternoon of the signing.<sup>11</sup></p>
<p>Though much has changed since the 1930s, this dismal record is still applicable. Certainly, the loss of inexpensive imports cannot help but cut the average American's buying power. And equally as certainly, the rest of the world would retaliate, as it did 84 years ago. When, for instance, the United States blocked Mexican trucks at the border, despite NAFTA rules, Mexico City placed tariffs of between 10% and 45% on 89 American products, until Washington relented.<sup>12</sup> The buy-American provisions of Washington's 2009 stimulus bill elicited complaints and threats from Canada, Europe, and Asian trading partners.<sup>13</sup> When Washington imposed a 35% tariff on Chinese tires, Beijing immediately imposed comparable tariffs on U.S.-made auto parts and agricultural products. More, it threatened to sell its vast holdings of U.S. government bonds and warned American firms operating in China that they would face reprisals if they could not get Washington to relent.<sup>14</sup> This is a partial list, to say the least. Such tit-for-tat protectionist actions are on the rise across the globe.<sup>15</sup></p>
<p><b>Leadership</b><br>
If the United States wants to use trade to relieve the effect of its demographic reality—and it needs to do so—the country's leadership will have to find ways to counter these protectionist trends, both at home and abroad. That will require global leadership from a Washington that has shrunk from it in recent years. Enlightened and determined American leadership may, in fact, be the only way to overcome the protectionist temptation and its potential to cause so much economic harm, especially in the demographically pressured future. In a different world, the United Nations might lead such an effort, or the WTO, but in reality neither of these organizations has the influence or the power to do the job. Nor does the European Union, especially in its current crisis, nor Japan, though both these regions have powerful interests in promoting free trade as well, for they face even more intense demographic pressure from aging populations than does the United States. China, too, for all its growing stature, doesn't have the diplomatic reach and its markets are not open enough to play such a role.</p>
<p>For Washington to lead, it would have to change its recent direction. Difficult as change is, current and future American leadership at least has the example of the not so distant past to guide it. Whereas these days, Washington jockeys for partisan position and threatens its own trade restraints, the government—from the end of the Second World War until the 1990s—steadily pursued the kind of multilateral free-trade agenda that the world now needs to cope with its demographic imperatives. During those decades, it strived to dismantle trade restraints universally across the entire international community. In the early 1960s, the so-called Dillon Round of trade negotiations got a universal 10% tariff reductions.<sup>16</sup> The Kennedy Round in the late 1960s and the Tokyo Round in the 1970s made further tariff-cutting strides, and removed other sorts of trade restrictions as well, again universally across the whole trading community.<sup>17</sup> The picture began to change in earnest in the 1990s. That was when the United States turned from the promotion of free trade generally and began to seek partisan advantage. It was then, too, that Washington began to pursue particularized exclusionary agreements. NAFTA was the first. It included Canada and Mexico, but excluded all others. Washington has proceeded in these ways since, hardly the global perspective it once used and needs now.</p>
<p>To be sure, Washington lacks the relative economic and political power it had in these early years. It can, however, still return to its former policies and exert broad-based free-trade leadership. The first step would require a turn from such exclusionary arrangements—what trade economists call <i>preferential trade agreements</i> (PTAs). This is an area that has received little media attention. Indeed, much of the media treats such preferential arrangements as a step toward free trade. To be sure, they exhibit a more open attitude than a strict form of protectionism, of the sort followed by Smoot-Hawley—but still, they hardly promote broad global trade liberalization. The difference is crucial, as prominent trade theorists have pointed out. Jagdish Bhagwati, for example, has gone so far as to label the recent U.S. approach as that of a &quot;selfish hegemon,&quot; echoing the great international economist Charles Kindleberger, who referred to this country's former global efforts as the policy of an &quot;altruistic hegemon.&quot;<sup>18</sup></p>
<p>Another way Washington, despite its relatively diminished stature, can promote a more global approach is by working through international organizations. Take, for instance, its trade friction with China. Instead of pushing China with threats of tariffs or other punishments, Washington might do better to challenge Beijing within the Group of 20 (G20), which adds 16 of the world's leading trading nations to the Group of 8 (G8) major developed economies. Many of the G20's members, the Europeans especially, object to Beijing's policies, accusing Beijing of managing its currency to give China's producers an export edge on global markets. If the United States could work with Europe, Japan, India, Indonesia, and others at the G20 who have their own reservations about Chinese policy, it might well do more to move Beijing than has the trade belligerence Washington has shown for the last couple of decades.<sup>19</sup></p>
<p>Alternatively or additionally, the United States could pressure China, or other nations that pursue unfair trade practices, through other international bodies. The International Monetary Fund (IMF) is one. Washington could, for instance, promote the new rules proposed by IMF staff to thwart currency manipulation, such as many accuse China of doing. These would forbid any nation to buy another's bonds or other liabilities unless it opens its financial markets.<sup>20</sup> To date, Washington has all but ignored this useful device, favoring instead tariff threats as a negotiating tool. To be sure, such positioning may still not move Beijing, but it would make it easier for China's leadership to accommodate. Singular American threats seem only to inflame China's already ridiculously inflated sense of nationalism. In still another way, the United States could pressure China and other uncooperative nations by inducing international bodies to deny these countries the elevations and status they covet until they play by global free trade rules.<sup>21</sup></p>
<p>There are no guarantees, however, that such efforts would move Beijing or any other uncooperative nations or promote a more liberal global trade environment. But such approaches, including a turn away from preferential trade agreements, certainly raise the global free-trade agenda to a status it lost decades ago, and needs now. This alternative approach also would carry less risk of trade war than this country's current partisan positioning. At least on that basis, the alternative approaches offer greater assurance that could blunt protectionist sentiment at home and abroad and establish the more liberal global trade environment that this country and others need to help relieve the strains of its aging demographics.</p>
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<p><sup>1</sup> For a thorough review of the change in public sentiment and in the political response, see Milton Ezrati, <i>Thirty Tomorrows</i> (Thomas Dunne Books/St. Martin's Press; forthcoming April 2014), especially Chapter 8.<br>
<sup>2</sup> See, for instance, Josh Gerstein, &quot;During Debate, Democrats Talk of NAFTA Withdrawal,&quot; <i>The New York Sun</i> February 27, 2008, and James Politi and Edward Luce, &quot;Democrats Tougher Anti-Trade Rhetoric,&quot; <i>Financial Times</i>, May 7, 2008.<br>
<sup>3</sup> John Harwood, &quot;Republicans Skeptical on Free Trade,&quot; <i>The Wall Street Journal</i>, October 4, 2007.<br>
<sup>4</sup> Holly Yeager, &quot;Senators Drop Call for Chinese Tariffs After Paulson Meeting,&quot; <i>Financial Times</i>, September 29, 2006.<br>
<sup>5</sup> For a more extensive and detailed catalogue, see Milton Ezrati, <i>Thirty Tomorrows</i> (Thomas Dunne Books/St. Martin's Press; forthcoming April 2014), Chapter 11.<br>
<sup>6</sup> Ibid.<br>
<sup>7</sup> Ibid. (especially chapter 10).<br>
<sup>8</sup> &quot;Smoot-Hawley Tariff Act,&quot; Encyclopedia Britannica website, www.eb.com<br>
<sup>9</sup> Quoted in Douglas A. Irwin, &quot;The Smoot-Hawley Tariff: A Quantitative Assessment,&quot; working paper 5509, National Bureau of Economic Research, March 1996.<br>
<sup>10</sup> Ibid.<br>
<sup>11</sup> See Chen Deming, &quot;Protectionism Doesn't Pay,&quot; <i>The Asian Wall Street Journal</i>, February 20, 2009.<br>
<sup>12</sup> &quot;Mexico Realties,&quot; editorial, <i>The Wall Street Journal</i>, March 19, 2009.<br>
<sup>13</sup> Sarah O'Conner, &quot;U.S. Companies Suffer Repercussions from Buy American Initiatives,&quot; <i>Financial Times</i>, March 17, 2010.<br>
<sup>14</sup> Keith Bradsher, &quot;Chinese Move to Retaliate Against U.S. Tire Tariff,&quot; <i>The New York Times</i>, September 14, 2009, and Stephanie Kirchfgaessaer, &quot;China Hits Out at U.S. 'Protectionism',&quot; <i>Financial Times</i>, June 6, 2008.<br>
<sup>15</sup> David Pilling, &quot;Will China's Coke Moment Spark Retaliation?&quot; <i>Financial Times</i>, March 26, 2009.<br>
<sup>16</sup> Kendal W. Stiles, &quot;The Ambivalent Hegemon: Explaining the 'Lost Decade' in Multilateral Trade Talks, 1948-58,&quot; <i>Review of International Political Economy</i> (Winter 1995).<br>
<sup>17</sup> Anne O. Krueger, &quot;Prospects for Liberalizing the International Trading System,&quot; working paper 2409, National Bureau of Economic Research, October 1987.<br>
<sup>18</sup> Jagdish Bhagwati, &quot;The Selfish Hegemon Must Offer a New Deal on Trade,&quot; <i>Financial Times</i>, August 20, 2008.<br>
<sup>19</sup> Thomas Wright, &quot;America Must Find a New China Strategy,&quot; <i>Financial Times</i>, August 9, 2010.<br>
<sup>20</sup> For a description of this proposal, see Martin Wolf, &quot;How to Fight the Currency with a Stubborn China,&quot; <i>Financial Times</i>, October 6, 2010.<br>
<sup>21</sup> For a list of such opportunities, see Bob Davis, &quot;Short List of Options for the U.S. on Yuan,&quot; <i>The Wall Street Journal</i>, October 8, 2010.</p>
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Mon, 27 Jan 2014 14:14:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/brother-can-you-spare-a-bitcoin.htmlBrother, Can You Spare a Bitcoin?<div class="everything">
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<h3><span class="articlePhrase">The electronic currency has attracted attention from speculators and financial media, but it's unlikely to upend the existing monetary order.</span></h3>
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<p>Bitcoin certainly has gained media attention since it first broke on the scene in 2009. It is understandable that it should. The system of this virtual currency effectively marries the attractions of gold to a mysterious and really cool technology. Talk about the ultimate power couple! Just about every financial person in the country has had to field questions on bitcoin—from clients, from colleagues, from journalists. Many have had to admit ignorance, some partial, some complete. Faking it on this subject is not an option—and never should be. This discussion is a general response to some of those questions. Its conclusion is that bitcoin, for all its remarkable appeal, cannot and will not supplant more conventional currencies or much alter the global monetary environment.<sup>1</sup></p>
<p><p>This relatively new phenomenon is definitely an alternative currency to those run by the central banks of the world. Like frequent flyer miles, it is purely electronic, but unlike frequent flyer miles, it has use with more than just one vendor. People can buy goods and services across the globe simply by sending bitcoin via the Internet from their electronic &quot;wallet,&quot; as the bitcoin folk like to say, to any another electronic wallet. All the vendor has to do is set up the wallet and agree to accept bitcoins. The list of merchants who take bitcoins is growing rapidly, in part because people want to use them, in part because bitcoin charges the merchant a lower fee than most credit or debit cards. Even some pizzerias take them. The new currency has gained, quite literally, greater currency.<sup>2</sup></p>
<p>With a limited supply, this increased usage has driven up the value of bitcoins when measured in other currencies. The dollar-exchange rate has, for instance, gone from $13 per bitcoin last January to a high of $1,200 late in 2013, though pricing is neither centralized nor is there an authoritative source. Such a price appreciation, and a good deal of volatility along the way, has attracted both investment and speculative interests. There is some suggestion, in fact, that most of the interest in bitcoin today is as an investment or as speculative, rather than for a commercial transaction. For the everyday investor, the volatility may look more like risk than opportunity. A further risk in bitcoin is the law. It is hardly settled and very well could change. Bitcoin also lacks a certain security that other investments or conventional currencies have. Of course, everything is subject to price fluctuations; but with bitcoin, the lack of registration could result in total loss. The only place to custody bitcoin is either on the owners' hard drive, the electronic equivalent of the mattress, or in a bitcoin wallet service. The failure of either could simply wipe away the asset without a trace, like cash in a fire. And several bitcoin wallet services have imposed this fate on holders simply by going out of business.</p>
<p>Against such risks, bitcoin does offer several attractions beyond the obvious chance of a handsome dollar return from a well-timed purchase. It is a clever, some say elegant, solution to a long-standing payments problem. Such innovation naturally attracts tech enthusiasts, if only for the affiliation. For more egotistical geeks, it offers another way to claim that the internet, they, and their sort will eventually rule the world. For those who seek privacy, bitcoin offers anonymity, like cash transactions, but with the added attraction that it can span the globe almost instantaneously. For those who distrust government and central banks, it offers an alternative to conventional currencies, the way gold does. But though bitcoin offers fulfillment on all these fronts, it still seems unlikely to go as far on any one of them as its enthusiasts like to claim.</p>
<p>There is no denying that bitcoin's founder, Satoshi Nakamoto (a pseudonym that roughly translates from the Japanese as &quot;clear thinking in the basics&quot;), is a person of genius. He or she has shown the world how to arrange a payments system without a central clearing house. Previously, all believed that a central clearing mechanism was essential to keep track of money flows and to ensure that holders could not spend their holdings more than once. Nakamoto, with a remarkable application of the otherwise commonly used public-key encryption, showed how wrong this presumption was. His or her system uses the encryption to protect the holdings and the anonymity of the transactions while at the same time making elements of the exchange public, in what the techies call a &quot;block chain,&quot; which effectively is a record of all the movements of a particular pool of bitcoin. Others in the system can then examine these chains to verify the legitimacy of each new transaction. The system encourages people to do the intense mathematics of verification by awarding them new bitcoin. Because these mathematical puzzle solvers, called &quot;bitcoin miners,&quot; are just others in the system, the payment network refers to itself as a peer-to-peer system.</p>
<p>Nakamoto's solution opened tremendous possibilities, at least in theory. Without the need for a central clearing house, he or she has invented a currency without the need for a central bank. In that sense, bitcoin takes on the quality of gold in the monetary system. Also like gold, the overall supply varies little. The bitcoin system limits the amount issued over time and also sets an overall limit on how many bitcoins can ultimately be issued. There can, in other words, be no quantitative easing or open market operations with bitcoin, no discretionary monetary policy at all, for that matter. Unlike gold, but like cash, public key encryption offers bitcoin transactions complete anonymity. There is, clearly, an appeal here to those contemplating illegal or illicit activity to whom the anonymity of cash has always appealed. But on a slightly higher plane, the anonymity and freedom from any central authority appeals to any who suspect the competence or integrity of monetary and other governmental entities, those, for instance, who worry that quantitative easing ultimately will lead to inflation.</p>
<p>But for all its appeals (and the hopes and expectations that have gone along with them), bitcoin has distinct limitations. The cap on the supply, currently set at 21 million units, constrains liquidity enough to raise questions about the currency's ability to challenge any but the smallest conventional currency. Were bitcoins used sufficiently to make a more important challenge, demand would so far outstrip availability that its exchange rate would rise into the stratosphere. Even if people then were willing to deal in fractional amounts, beyond the eighth decimal place to which bitcoin trades today, the system would still have a hard time meeting the liquidity and transactional demands of a normal currency, much less a major world reserve currency, as some enthusiasts have suggested it someday might. Gold has a similar problem as a substitute currency, but looks abundant by comparison to bitcoin.</p>
<p>Nor is the much touted and, for some, attractive anonymity secure. Right now, the public key approach seems to work, but the amount of theft alluded to in the bitcoin commentaries (there are no statistics) suggests that matters are not so well protected as they seem theoretically. And intrusive hacking technologies are always advancing. After all, Target thought its credit card records were secure. Efforts to hack into the system and peoples’ wallets would grow disproportionately as bitcoin becomes more popular and bitcoin, accordingly, becomes still more valuable. Meanwhile, such growth would almost surely prompt the authorities to direct their ample resources to discovering who is buying what from whom with bitcoin.</p>
<p>If this currency, however elegant its technical achievement, is fundamentally limited, the passion expended in discussions of it, both pro and con, makes an interesting spectacle and an equally interesting footnote to this discussion. Much of the debate on bitcoin actually reveals more about the political-economic biases of the debaters than about the subject. The libertarian crowd at the Cato Institute, for instance, or clustered around former congressman Ron Paul (R-TX) or&nbsp;Senator Rand Paul (R-KY), seems willing to ignore practical constraints in order to have something through which to criticize existing monetary arrangements. On the other side stands an angry Paul Krugman, the <i>New York Times</i> columnist.<sup>3</sup></p>
<p>He is less than enthusiastic, and has actually entitled one of his recent columns, &quot;Bitcoin Is Evil.&quot; There, and in his blogs, he makes two moral judgments, a strange thing indeed to do with a currency. Both judgments seem less than well informed. He claims that the award of bitcoin for solving mathematical puzzles is &quot;socially wasteful.&quot; Never mind that people would have little to do were the economy to ban all socially wasteful activity—he misses the point that the problem solving is not a game but rather a way to facilitate the payments mechanism. It is, then, no more or less wasteful than check clearing. Krugman also criticizes bitcoin as unreliable because it is only as valuable as people think it is. Since this distinguishes it not at all from dollars or gold or any other asset, good, or service, it seems a strange argument for a noted economist to make. No doubt it is less a misunderstanding on Krugman's part than simply a handy way to criticize something he does not like, most likely because it offers people a way to sidestep government, one thing Professor Krugman clearly does like, very much.<sup>4</sup></p>
<p>If bitcoin is not nothing, neither is it the revolution some fans claim nor the &quot;evil&quot; Krugman and others like him see. To the extent that it has revealed the lengths to which partisans will go in today's debates, it has provided the world with at least one valuable service. Certainly, getting an otherwise brilliant economist to make an undergraduate mistake has to be worth something. Otherwise, bitcoin will continue to provide an interesting outlet for an increasing number of transactions and an alluring source of interest. It is, however, not a challenge for conventional monetary or payments systems.</p>
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<p><sup>1</sup> For more detail on the bitcoin, see, for example, the Wikipedia entry on bitcoin; Adam Serwer and Dana Liebelson, &quot;Bitcoin, Explained,&quot; <i>Mother Jones</i>, December 31, 2013; and &quot;Bits and Bob,&quot; <i>The Economist</i>, June 13, 2011.<br>
<sup>2</sup> Anders Bylund, &quot;Should You Buy Some Bitcoin Today?&quot; The Motley Fool, December 26, 2013.<br>
<sup>3</sup> Timothy B. Lee, &quot;Here's What Paul Krugman Doesn't Get about Bitcoin,&quot; <i>The Washington Post</i>, December 23, 2013.<br>
<sup>4</sup> Paul Krugman, &quot;Bitcoin Is Evil,&quot; <i>The New York Times</i>, December 28, 2013.</p>
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Tue, 21 Jan 2014 18:36:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/fiscal-policy-nothings-certain-with-debt-and-taxes.htmlFiscal Policy: Nothing's Certain with Debt and Taxes <div class="everything">
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<h3>After the budget deal, markets will have to contend with two wild cards in Congress: the debt ceiling and tax reform.</h3>
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<p>The passage of a two-year budget deal has lifted one great investment uncertainty hanging over 2014 and, along with it, an element of fiscal drag on the economy. Still, the weight of Washington remains going into this new year, as we likely will see in February and March an acrimonious fight over the debt ceiling. Market turmoil will surely accompany the political back and forth, though the inevitable threats of a government shutdown and default will grossly overstate the real danger. A potential bright spot on this horizon, however, is the chance of tax reform, which both Democrats and Republicans say has gained new life from the recent budget compromise. Though the prospects of substantive reform appear slim, especially since the White House is still not on board, the fiscal picture for 2014 is more upbeat on balance than it has been in a while.</p>
<p>Though the budget deal may reflect exhaustion more than the new bipartisan spirit of which people speak, it does resemble a genuine compromise. There is something for each side and reason for frustration and disappointment by partisans on either side. For the Democrats, the compromise offers relief from the sequester that in 2014 would have capped discretionary spending, including defense, at more than $100 billion short of what ongoing budget authority would have allowed. This new budget allows a two-year increase of $63 billion in discretionary spending over current law (as set in last fall's continuing resolution), about $44 billion above the amount a sequester would have allowed. That is considerably less fiscal restraint. But the Republicans have hardly given away the sequester. According to this deal, its caps on discretionary spending return in 2016, unless Congress can arrive at another compromise.<sup>1</sup></p>
<p>To keep the budget deficit from increasing with this additional discretionary spending, the deal imposes a mélange of fees and spending cuts, amounting to some $85 billion over 10 years. In one, the Transportation Security Administration (TSA) would raise the fees it charges airlines, from $2.50 per passenger on nonstop flights and $5.00 on flights with a connection, to a straight $5.60 per passenger for each one-way trip, regardless of connections. The deal would for the first time impose a $487,000 cap on the compensation of federal contractors. To prevent fraud, it would for the first time limit access to the Social Security Administration's Death Master File of dead Americans, including their Social Security numbers. This, and fees like it, would, the legislation claims, raise $26 billion over 10 years. More significantly, the deal would ask new federal workers to contribute 2.1% to their pension, up from 0.8% for existing employees. It would also limit the annual cost of living adjustments for military retirees under 62 to the consumer price index less one percentage point.<sup>2</sup></p>
<p>For the basic budget picture, the deal does little. The whole picture promises a net deficit reduction of some $23 billion over 10 years—effectively a rounding error. The negotiators did say that they were aiming small, knowing that they could not compromise on anything large or fundamental. They certainly have been true to their word.<sup>3</sup> Even small in scope, there is much yet to do before January 15, when the continuing resolutions of last fall run out. Committees in both house of Congress must make specific appropriations for various parts of the budget and in the process resolve remaining differences over specific spending priorities as well as disputes over the policy riders attached to the legislation. Even then both houses must vote on the 12 appropriation bills, probably as one omnibus measure. By that time, Congress will have six weeks to resolve the debt ceiling matter before the country hits it, in early March, according to the Treasury Department.<sup>4</sup></p>
<p>The specifics of this debate are far from clear, but from statements on both sides, there is little bipartisan spirit when it comes to the debt ceiling. White House press secretary Jay Carney has gone on record saying that President Obama will not negotiate on the debt ceiling. The president wants what he has called a clean increase, meaning with no strings attached. But Congressman Paul Ryan (R-WI), who led the Republican negotiating team on the budget deal, has already gone on record saying that they didn't want anything out of this debt limit.<sup>5</sup> Like others in his party, Ryan is willing to raise the debt ceiling, but he just wants something back for it. More conservative Republican representatives and senators are talking about major entitlement reforms as their own quid pro quo. Senator Marco Rubio (R-FL) is looking for a package of spending cuts in return for an increase in the debt ceiling.<sup>6</sup></p>
<p>Only a fool, though, would try to predict the results of these upcoming negotiations. The president, despite the claims of his partisans, has not always prevailed. Indeed, the sequester itself is a concession he made to resolve the 2011 debt-ceiling negotiations. But even so, it does seem highly unlikely that the Republicans can get significant entitlements reforms out of even the best executed negotiations, much less what they have exhibited to date. The president and the Democratic Party simply hold Social Security, Medicare, and now the Affordable Care system as too sacred. But if it is impossible to determine what will come out of the debt-ceiling debate, it is clear that investors will almost certainly avoid another government shutdown, much less the default that various parties will inevitably threaten. After the agony suffered by both parties last fall, few, if any, have the stomach for a rerun.</p>
<p>If the debt-ceiling matter will likely give markets little cheer, but also little fear, several in Washington have raised the prospect of good news over tax reform. Congressman Ryan, for example, suggested that a tax overhaul could become a real possibility &quot;in the first quarter.&quot; Senator Patty Murray (D-WA), who led the Democratic negotiating team on the budget deal, has reinforced the optimism, saying at Ryan's side that Democrats, too, want tax reform.<sup>7</sup> Senator Max Baucus (D-MT) and House Ways and Means Committee chairman Dave Camp (R-MI) noted that the budget deal did nothing to end tax breaks, and promised that they would come up for consideration soon in tax reform negotiations.<sup>8</sup> Of course, markets would welcome pro-growth reform. The prospect of lower statutory rates, a broader base, and fewer distorting tax breaks is popular in the finance community. But reform is far from easy and far from done. Such titillating promises have surfaced before. Significantly, the White House has endorsed nothing, and little progress is likely without the president's support. Still, even just the open consideration of such reform could lift investors' spirits, especially once debt-ceiling concerns are behind them.</p>
<p>As ever with Washington, matters are convoluted, and the message to the investment community is mixed. The budget deal, though it lifts a measure of uncertainty that formerly confronted Wall Street and should mitigate the degree of financial drag acting on an already weak economy, is far from an investor's ideal. The upcoming debt-ceiling debate, though bound to create market turmoil, is likely to avoid the most feared outcomes, and the push for pro-growth tax reform, though unlikely to become a reality, especially in the face of White House passivity, will provide a psychological lift simply from the fact that both sides of the aisle are discussing it. On balance, then, the picture, though far from cheery, is less threatening than it seemed in the past.</p>
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<p><sup>1</sup> Dow Jones News Wire, December 10, 2013.<br>
<sup>2</sup> Ibid.<br>
<sup>3</sup> Ibid.<br>
<sup>4</sup> Janet Hook, &quot;Parties' Budget Haggling Shifts,&quot; <i>The Wall Street Journal</i>, December 18, 2013.<br>
<sup>5</sup> Justin Sink, &quot;White House: No Debt Ceiling Negotiation,&quot; <i>The Hill</i>, December 16, 2013.<br>
<sup>6</sup> Carol E. Lee and Damian Paletta, &quot;Republicans Promise New Fight Over Debt Limit,&quot; <i>The Wall Street Journal</i>, December 17, 2013.<br>
<sup>7</sup> Russell Berman, &quot;Ryan: Watch for GOP Tax Reform,&quot; <i>The Hill</i>, December 15, 2013.<br>
<sup>8</sup> Bernie Becker, &quot;Tax Reformers See Hope in Budget Deal,&quot; <i>The Hill</i>, December 15, 2013.</p>
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Mon, 13 Jan 2014 10:47:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/dramatically-dropping-deficits-keep-dreaming.htmlDramatically Dropping Deficits? Keep Dreaming <div class="everything">
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<h3>A smaller U.S. budget shortfall for fiscal 2013 will be largely due to transitory factors.</h3>
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<p>The Congressional Budget Office (CBO) recently reported remarkable budget improvements for the fiscal year 2013. It recorded a deficit of $680 billion for the year, still huge, but encouragingly down from $1.089 trillion of fiscal 2012—a stupendous drop of more than one-third, in fact. This kind of progress seems almost too good to be true. In one certain sense, it is. None of this doubt suggests in any way, of course, that Treasury or the CBO has cooked the books. On the contrary, the figures are surely accurate, or as accurate as such figures can be. But still, the progress implicit in this report is deceptive. The gains of fiscal 2013 rely in large part on a number of transitory special influences that will not recur going forward, or not recur with the same intensity. Those who simply extrapolate last year’s gains will be disappointed. Fiscal 2014 at best will only very modestly extend the improvements of fiscal 2013.<sup>1</sup></p>
<p><p>Though the release went largely unheralded in the media, the figures for the fiscal year ended this past September were indeed impressive. According to the CBO, Treasury receipts jumped $325 billion, or 13.3%, which is remarkable, especially given that the economy expanded less than 3% in real terms and that revenues during the prior three years of recovery expanded on average at only 5.2% per year. Outlays fell a modest 2.4%, or $84 billion. Under those two influences, the overall deficit shrank, as indicated, by more than a third. Though during the prior three years the flow of red ink had ebbed, the pace of improvement hardly compares to fiscal 2013. The deficit shrank by a mere 8.3% per year between fiscal 2009 and fiscal 2012, from $1.4 trillion to $1.1 trillion. As a part of the country's gross domestic product (GDP), the fiscal 2013 deficit fell to 4.1%, still high compared with the historical averages, but vastly improved from 9.8% in fiscal 2009, 8.8% in fiscal 2010, 8.4% in fiscal 2011, and 6.8% in fiscal 2012.</p>
<p>The optimist in everyone would dearly love to extrapolate this accelerated rate of improvement and declare Washington's fiscal problems a thing of the past. There is still a chance that Congress will interpret the figures in just this way and use them to dodge pressure for fiscal reform. But such interpretations would mislead and such actions would be negligent. They would ignore the number of special factors that influenced both revenues and expenditures last year and that will not provide the same financial magic going forward, at least not to the same extent.</p>
<p>1) The sequester cut spending after the first quarter of calendar 2013. It is, in fact, safe to say that the entire spending decline was due to it. Had it not occurred, the deficit would have come in at closer to $764 billion—still a significant improvement over fiscal 2012, but less dramatic than was actually recorded. Though the sequester will likely become more significant going forward, additional absolute cuts are unlikely. The law, after 2013, administers the sequester as a cap on actual outlays. The gap between actual spending and still growing budgeted amounts will widen, but these rules will just stop spending growth and not impose any additional cuts. The reduced level of discretionary spending will indeed hold, but it will not likely fall any further, while entitlements spending, which is well over half the budget and subject to neither sequester cuts nor caps, will continue to expand uninterrupted.<sup>2</sup></p>
<p>2) Taxes rose in January 2013, because of higher rates on the wealthiest Americans and the end of the holiday on some Social Security and Medicare withholding. These heightened tax rates will continue going forward and continue to generate additional revenues flows to the Treasury. But the one-time leap in revenues that occurred with the 2013 changes in the law will not recur. There is nothing in these now ongoing taxes that will drive up revenues going forward much faster than payroll or income growth.<sup>3</sup></p>
<p>3) One-time tax avoidance efforts in 2012 ironically inflated fiscal 2013 tax payments. Because firms late in 2012 feared tax hikes in the new year, many telescoped into the last quarter of 2012 bonuses and dividend payments that they would otherwise have paid in 2013. The effect is significant. In that last quarter of 2012, these special payments help drive up wage and salary income at an 11% annual rate, far faster than the 3.1% rate of expansion averaged during the prior four quarters. Dividend income jumped 16.8% at an annual rate in that quarter, far faster than the 3.9% rate of expansion during the prior four quarters. Though these payments accrued to 2012 taxes, there was little withholding, and so they were mostly paid last April, inflating the fiscal 2013 take. The figure was significant, too. Revenue flows in April 2013 rose by a stupendous 27.8% over April of the prior year. But no such special boost will occur this coming April. On the contrary, because the telescoped payments of 2012 drew from monies that normally would have been paid in 2013, the revenue flow this coming April 2014 may well fall short.<sup>4</sup></p>
<p>4) The improvement in the housing market enabled Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corp.) to turn a net draw on Treasury revenues into a positive contribution of $60 billion in fiscal 2013. Alone this swing accounts for more than 25% of the overall deficit improvement. Though a continued improvement in the housing market will enable Fannie and Freddie to enlarge this contribution, the net addition going forward will likely fall far short of the fiscal 2013 swing, not the least because the pace of improvement in residential real estate has slowed.</p>
<p>For all these reasons, deficit improvements going forward will fall far short of the inordinate gains made in fiscal 2013. Some progress is likely. Revenues should marginally outpace overall income growth. After all, the progressive tax code allows the Treasury on average to tax each additional dollar earned at a higher rate, and this effect should more than offset the give back for the revenue collected on the telescoped bonuses and dividend income. Receipts, then, could rise about 5% in fiscal 2014, to $2.913 trillion. On outlays, the Affordable Care Act, though it will eventually increase entitlements spending, will have only just begun next year and so will remain a small factor in the overall equation. Still, along with the other, older entitlements programs, the expansion in this area of the budget should drive overall expenditures up an overall 2.5–3.0%, bringing the fiscal 2014 total to $3.549 trillion.</p>
<p>The fiscal 2014 deficit, under these admittedly tentative calculations, would then come in at about $636 billion, down about 6.0% from fiscal 2013. The smaller figure will be a welcome improvement, but exhibit a much slower pace of progress than last year, slower even than the deficit declines between 2009 and 2012. Still, even this modest deficit drop would bring the flow of red ink to less than 4.0% of GDP in fiscal 2014, finally approaching the levels averaged before the 2008–09 crisis. Still, the result will disappoint any who extrapolate the fiscal 2013 experience whether investors, planners, or members of the government.</p>
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<p><sup>1</sup> All data herein from the Office of Management and the Budget, unless otherwise indicated.<br>
<sup>2</sup> Department of Commerce.<br>
<sup>3</sup> Ibid.<br>
<sup>4</sup> Ibid</p>
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Mon, 2 Dec 2013 22:10:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-future-in-focus-our-demographic-destiny.htmlThe Future in Focus: Our Demographic Destiny<div class="everything">
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<h3>In the first of a series on population trends that will shape the U.S. economy, Milton Ezrati looks at the policy challenges posed by an aging America.</h3>
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<p>During this brief lull between crises in Washington, investors might do something the government seems loath to do: consider longer-term fundamentals. One critical matter on this more distant horizon is the increasing average age of the country's population. Because this trend will impose an expanding number of dependent retirees on an ever-more constrained relative number of working-age people, it will have profound financial and economic repercussions. These will not, however, follow the disastrous outlines occasionally outlined in the media's simple extrapolations. On the contrary, the United States will almost certainly change to protect its prosperity, seeking ways to increase worker productivity, for instance, get more of the existing population to participate in the workplace, tap immigrants, and increase levels of trade and globalization. All should help this economy cope with its demographic imperatives. The effort will, however, require some wrenching changes in the structure of industry and in business practice, and these will inevitably create investment opportunities.</p>
<p><p>This is a big subject, too big for a single weekly website discussion. The plan is to cover various aspects of this matter in a series of weekly pieces, issued as immediate crises and contingencies allow. This first column will set the tone, describing the demographic imperatives facing the country, outlining the dangers they threaten, and indicating where the various responses fit into the picture of the longer-term future. More focused discussions of each response will follow.</p>
<p>This country's demographic problem has two roots. Increases in public health and tremendous advances in medical science have greatly increased life expectancies. On average, a baby born today in the United States can expect to live for almost 80 years. This is up from an expected 74 years in 1980 and an expected 69 years in 1950, effectively an almost 7% extension in life expectancy in the last 30 years and an almost 15% extension in the last 60-some years. At the same time, a drop in fertility rates has slowed the flow of young people into the workforce. In 1950, for example, the average American woman had 3.5 children in her lifetime. By 2010, according to Bureau of Census estimates, that figure had dropped to 2.0, barely enough to sustain the existing population.<sup>1</sup></p>
<p>The confluence of these two trends will put the country into a predicament that it has never before faced. The proportion of people of retirement age, according to the Census Bureau, will grow from 12.8% of the population today to about 15% by 2020 and to about 20% by 2030. Meanwhile, because of the constrained flow of younger people into the workforce, the number working will fail to keep pace with this anticipated expansion in the dependent older population. The Census Bureau calculates that the number of working age available to support each retiree will fall from 5.2 today to 3.7 by 2020 and to only 3.0 by 2030. Fewer workers available to support a greater number of dependent retirees cannot help but force change on the economy and its financial markets.</p>
<p>Best known of these strains is the predicament faced by Social Security and Medicare. Contributions from existing workers will fall ever shorter of the growing demands of this enlarging retired population. But the impending insolvency of Social Security and Medicare are only part of the coming financial difficulties. Private savings will likely fall short of the flows needed to support other pension plans, those maintained by state and local governments in particular, but also private pension and retiree medical plans that have retained a defined benefit structure. These plans theoretically avoid the pitfalls of a pay-as-you-go system used by Social Security and Medicare by backing their obligations with pools of invested assets. But even these investment pools will have a harder time sustaining acceptable levels as reduced relative numbers of new workers slow the flow of contributions relative to the growing numbers of retirees drawing on the plan.</p>
<p>There is a third financial problem. As an even larger part of the population retires, they will tend to draw down on their savings and investments instead of adding to them. Such selling pressure could limit or even undermine the basis of long-term market appreciation. To be sure, this particular problem will not develop for some time, as the largest portion of the baby-boom generation is still in its fifties, with an increasing tendency to save and invest for some time to come. But over a longer time frame, as this portion of baby boomers passes into retirement, this financial threat will build.</p>
<p>If the economy could produce enough added wealth, these financial strains would be easily managed, but as it is, the demographic imperative also is likely to hold back the economy. The relative shortage of workers will, all else being equal, limit the economy's productive power, including its ability to provide the consumption and other economic needs of these retirees. It may be hard today, in the face of a huge army of unemployed, to envision a time when such a relative labor shortage exists, but it is important to realize that these are long-term trends, while today’s high unemployment, stubborn as it has been, is fundamentally a cyclical phenomenon. And if, as many suggest, unemployment stays high because of a mismatch between the skills the economy needs and those that exist in the workforce, the financial and economic burden on those reduced relative numbers working will become that much more unsupportable, as these workers will have to produce enough for themselves and their immediate dependents, the country's retirees, and also for those effectively unemployable because they lack needed skills.</p>
<p>A worsening relative shortage of working hands and minds, especially of those with the appropriate skills, will necessarily tend to limit the economy's raw production ability and so also its growth prospects. What is more, the shortage of workers will tend to raise wages, at least for those with certain skill sets, and to that extent, impair growth prospects, some research estimates by 10%.<sup>2</sup> While that shortfall might have immediate ramifications in financial markets, more fundamentally it also will tend to deprive business of the wherewithal for capital spending. To that extent, matters will further impair growth prospects by constraining the main means by which business increases its productivity and its overall productive capacity. Some academic research estimates that these and lesser economic effects will tend to slow the economy's real growth rate by one-fifth. Other work suggests that in the absence of remedial efforts, this demographic pressure could reduce the economy's historical growth pace by two-thirds.<sup>3</sup></p>
<p>Rather than accept such economic and financial hardship, there is every reason to expect the economy, even without central direction (perhaps especially without central direction) to seek remedies. One would increase productivity. With fewer numbers of workers relative to production needs, an increase in the average hourly output of each worker could cover some of the productive gap left by the demographic reality. Of course, the indicated profits shortfall and other financial strains will make such efforts more difficult. Perhaps a rising wage for skilled labor well provide a counterbalancing incentive for business to make the effort anyway. Along similar lines, the economy could cover some of the relative labor shortfall by increasing the population's participation in the workforce. Older people, for instance, might stay at work for longer. There is also a huge potential to increase women's participation. Even though during recent decades women have flooded back into the paid workforce, still only 70% of working-age women participate in gainful employment, compared with almost 90% of working-age men. The increased participation of either women or elders will necessarily involve greater flexibility on the part of firms, in order to, for example, change rules on hours, child support arrangements, and working conditions. The effort could ultimately alter the entire nature of the workplace.<sup>4</sup></p>
<p>The economy also can reach overseas to remedy the labor shortfall implicit in its demographic predicament. Increased immigration is one obvious avenue, but to have the desired effect, the country will have to target those with the skills it needs. Even then, because immigration sufficient to bridge the entire relative labor gap will almost surely cause social tension, it cannot provide the entire answer. More potential lies with increased trade and globalization. By increasing imports, the country can effectively relieve its productive shortfall by tapping foreign labor even as it remains at home. Especially by relinquishing labor-intensive, lower value-added activities to less developed economies while concentrating more on high-value-added, capital-intensive activities at home, trade and globalization can answer just about all the needs of the labor shortfall implicit in the demographic trends. But such a shift will require another considerable revamp in the structure of the economy, more than has taken place already, and also ever greater efforts at training and education in the domestic workforce.</p>
<p>Subsequent pieces in this space will elaborate on the nature of each of those remedies, the alterations they will require in industrial and business practice, and, of course, the investment opportunities that will accompany those changes. Even with a separate discussion dedicated to each, the space allowed here can hardly do the subject full justice. That requires a much longer treatment. Still, it will offer a summary view.</p>
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<p>* All the analysis presented here is draw from a new book, <i>Thirty Tomorrows</i>, forthcoming in April 2014 from Thomas Dunne Books.<br>
<sup>1</sup> Bureau of the Census, Department of Commerce.<br>
<sup>2</sup> David E. Bloom, David Canning, and Gunther Fink, &quot;Population Aging and Economic Growth,&quot; working paper 31, Harvard Initiative for Global Health Progress and the Global Demography of Aging, April 2008.<br>
<sup>3</sup> Dick Kruger and Alexander Ludwig, &quot;On the Consequences of Demographic Change for Rates of Return to Capital and the distribution of Wealth and Welfare,&quot; working paper 12453, National Bureau of Economic Research, August 2006.<br>
<sup>4</sup> Milton Ezrati, <i>Thirty Tomorrows</i> (New York: Thomas Dunne Books; forthcoming 2014).</p>
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Mon, 25 Nov 2013 22:02:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/golds-limited-luster.htmlGold's Limited Luster<div class="everything">
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<h3>The precious metal is back in the spotlight, but its prospects for price appreciation have dulled. Here's why.</h3>
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<p>The frequency with which gold comes up in conversation tells a lot about the prevailing levels of fear among investors. Whether concerns center on ill-considered fiscal or monetary policies, currency depreciation, debt default, inflation, or, remarkably, deflation, too, gold presents itself as an investment answer. Its price prospects depend, then, on whether the potential buyer believes consensus will become more afraid than it is or less. At present, there is still plenty to fear, but probabilities favor either a measure of relief or little change rather than more, suggesting that gold's price is more likely to fall further or hover where it is rather than rise.</p>
<p><p>Certainly this response by gold to the ebb and flow of worries emerges in the historical record. When gold hit its last big high in August 1980, at $627 an ounce (a bit more than $1,500 in today's prices), there was plenty to fear. The economy had slipped into recession again after a disappointing decade, inflation had risen to double-digit rates, the dollar had lost a big chunk of its foreign exchange value, and few had any confidence in the efficiency of either fiscal or monetary policy. But as former Federal Reserve chairman Paul Volcker's policies began to break the back of inflation and pro-growth fiscal policies prompted a secure economic expansion, these fears began to ebb, and gold's price dropped. By 1987, the price touched $400 an ounce, down 36% from the 1980 high. It spiked briefly late that year during the stock market crash, but with recovery in markets and continued economic growth, gold fell into the 1990s, especially as collapse of the Soviet Union relieved long-standing geopolitical concerns. By 1999, the price of gold hit $282 an ounce, down 57% below its highs of 1980.<sup>1</sup></p>
<p>Things changed after the attacks of September 11, 2001. Even as the economy emerged from recession and inflation remained well contained, gold prices rose in response to the uncertainties of the new war on terror. The price of an ounce passed $1,000 in 2008, in response in particular to the dollar's accelerating losses on foreign exchange markets and continuing problems in Iraq. The global financial crisis of late 2008–early 2009 intensified fears across a broad front and pushed up further the price of gold. Concerns over the developing crisis in Europe, the subpar economic recovery, and the ultimate inflationary effects of the extraordinary monetary ease used to fight the crisis pushed up prices in 2010 and 2011. That year, as the European crisis intensified and the &quot;Arab Spring&quot; brought new geopolitical concerns on top of everything else, the metal's price rose to $1,900 an ounce, up 90% from 2008 and almost 600% from the lows at the turn of the century.<sup>2</sup></p>
<p>Since those 2011 highs, the price has dropped dramatically. This decline has occurred not because concerns have gone away. On the contrary, all remain. But none now look as imposing as they did in 2011. The price of an ounce has fallen recently to about $1,300, down a bit over 30% on balance from the 2011 highs, but still well up from levels that prevailed before the financial crisis of 2008–09. Looking forward, there are persistent worries, but likelihoods suggest that fears will either stay at present levels of intensity or relax further. Here is how the various influences on gold's price look at present and their likelihoods for the future.<sup>3</sup></p>
<p>Central banks continue to buy gold, less out of strategic investment interest than as part of a long-term effort to diversify their reserve holdings. Similarly, individuals in South Asia and the Far East continue to buy, less for tactical investment reasons than as a form of ongoing savings. Retail purchases in the United States also persist in response to the hawking on television, Google ads, seemingly everywhere. Though these ongoing sources of demand will likely keep prices above where they otherwise might be, they are insufficient in themselves to drive up prices from current levels. They were, after all, in place even as gold prices fell precipitously after 2011.<sup>4</sup></p>
<p>So, too, the decision by the Fed to carry on with its extremely accommodative monetary policy leaves little reason to expect a sudden shift in gold prices. Of course, a continued flood of liquidity into the financial system tends to hold up the price of gold by threatening longer-term inflationary pressures. But this circumstance has prevailed for years now and surely has long been reflected in gold's price. It would seem, then, that a tapering in the flood of Fed-provided liquidity would relieve such inflationary fears and allow the price of gold to fall. But such a move is as likely to raise gold's price over fears about a shock to the economy as it is to drive it down over relief on the inflationary front. That, after all, is what happened when the consensus expected the Fed to taper the extent of quantitative easing. Gold prices actually rose briefly during that time last summer, from $1,250 an ounce to $1,400, only to fall back almost entirely when it became apparent in September that the Fed had decided to delay the policy shift. A steady state for the Fed is then more likely to hold gold prices even than anything else.</p>
<p>Washington will face renewed budget debates in the new year, as legislation to keep the government open expires in January 2014 and the country again will come up against the new debt ceiling in February, the Treasury estimates. Chances are that markets, including the gold market, will react to these coming troubles as they did to this last round, with caution, but with none of the panic promoted by Washington. For all of Washington's angst at the time, market tremors gave no sign of a concentrated rush to the security of gold. To be sure, a firm budget compromise would relieve much fiscal anxiety and push down the price of gold. But a grand bargain is hardly likely. Government will, in all probability, do what it has just done and has done for the last five years—agree to differ and postpone the decision, a pattern that will neither relieve nor intensify investor anxieties and so have slight net effect on gold's price.</p>
<p>Economic likelihoods offer little prospects of a shock either. Were the pace of real growth to accelerate, fears about the economic future would ebb and the price of gold would fall. But this potential is limited, for all the reasons such an acceleration has eluded this recovery so far. Still, the prospect of a relapse into recession, something that surely would raise anxieties and so also the price of gold, is even less likely. Though the pace of growth is disappointingly slow, the economy lacks pre-recessionary signs. Housing is expanding, albeit slowly, and home prices are appreciating. The economy has never gone into recession in the face of a real estate expansion, even a modest one. Corporations are flush with cash. If they remain cautious, the cash tells that they in no way face the financial squeeze that typically leads to cutbacks and recession. Households have improved their finances. With an admittedly slow but nonetheless positive payroll expansion, that financial improvement should allow continued moderate advances in consumer spending.<sup>5</sup></p>
<p>If the domestic economic climate looks unlikely to alter gold's pricing equation, prospects in Europe and on the currency front look balanced as well. There is little or no chance that Europe will dramatically reduce gold's price by finding a way out of its fiscal-financial mess anytime soon. Policy change simply is not moving fast enough. But at the same time, little suggests much further deterioration. The European Central Bank (ECB) shows a clear commitment to fighting the most intense strains of the situation, as does Berlin, especially in light of the September elections. If the European situation remains in its current, admittedly subpar, state, so, too, will the dollar-euro exchange rate. For the yen, likelihoods are for modest further dollar appreciation, which by itself would tend to reduce gold's price, though hardly enough to form a new trend. Nor would expected modest dollar depreciation against China's yuan offer enough of a move to change gold-price trends.<sup>6</sup></p>
<p>Geopolitics, as ever, remains a wild card. No doubt, direct action by the United States in Syria, even if &quot;incredibly&quot; minor, to steal the secretary of state's eloquence, would put upward pressure on the price of gold by threatening a wider war. To that extent, the current Russian &quot;solution&quot; to dismantle Syria's chemical weapon's stock, dubious as prospects are, has tended to hold prices down. The Iranian nuclear threat remains. An Israeli or U.S. military strike would, of course, greatly intensify fears and cause gold's price to spike upward, perhaps even beyond the old highs. But, impossible as it is to weigh odds on such an event, it is not unreasonable to proceed on the assumption that neither country is ready yet to make such a dramatic move. Short of such action, the Iranian tension has long had a presence in gold's pricing. To the extent that this latest round of negotiations makes progress, gold's price may well fall. If the diplomacy just drifts, as it has to date, it would change little in the pressures on gold's pricing.</p>
<p>The risks of a change in any one of these influences are undeniable. Much is unpredictable, especially since the price of gold hinges on so many considerations these days. But it is still reasonable to conclude from the balance of probabilities that prices will more likely decline or stay stable than increase. Even stability is hardly attractive, since gold pays neither a dividend nor interest.</p>
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<p><sup>1</sup> Bloomberg data.<br>
<sup>2</sup> Department of Commerce and the Department of Labor.<br>
<sup>3</sup> Paul Ausick, &quot;2013 Outlook for Gold and Silver: Risk in Gold, the Devil's Metal Shines,&quot; <i>Thinkstock</i>, December 21, 2013.<br>
<sup>4</sup> Federal Reserve.<br>
<sup>5</sup> Department of Commerce.<br>
<sup>6</sup> Milton Ezrati, &quot;The Secret of the Euro's Survival,&quot; Economic Insights, October 11, 2013.</p>
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Mon, 18 Nov 2013 21:52:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/the-secret-of-the-euros-survival.htmlThe Secret of the Euro's Survival<div class="everything">
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<h3><span class="articlePhrase">Despite fiscal strains and political controversy, the common currency still enjoys broad support among member nations. Here's why.</span></h3>
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<p>It appears that the euro and the eurozone will survive without expulsions, secessions, or, critically, defaults. The Continent's fiscal-financial crisis will almost surely go on, indefinitely it seems. The debt burdens are high, many of the zone's members have broken political-economic models, and the ongoing recessions and near recessions in many member countries will compound the financial strains for some time to come. But set against these difficulties, unity in the zone enjoys three broad supports: 1) a tremendous political will to continue the eurozone experiment; 2) continued support by the European Central Bank (ECB); and 3) tremendous pressures on Germany, Europe's paymaster, to sustain the euro and the eurozone as it is presently constituted.</p>
<p><p>It may seem counterintuitive, but all the debate, compromise, even the tensions that have overtaken Europe since the crisis broke in 2010 speak to a tremendous will among its members to make the currency union work. Each nation has maneuvered for the best deal it can get. The French and others have argued for zone-wide bonds to cover budget shortfalls, while the Germans, who know they will have the ultimate responsibility to meet such obligations, have refused. While some, particularly the Spanish, have looked for zone-wide funding of bank capital needs, Berlin has demurred until there is also effective zone-wide bank supervision. But in all these and other disputes, never once has a nation threatened to break off negotiations, much less withdraw from the common currency or the institutions that support it.<sup>1</sup></p>
<p>The commitment of the ECB in part reflects this impressive political will. It is, after all, an institution established by the same parties negotiating the ins and outs of the crisis. To be sure, the bank has at times talked out of both sides of its mouth. It has on occasion dragged its feet about providing liquidity to troubled financial markets, worrying over non-existent inflationary pressures instead of more immediate needs. The bank has, at various stages of this crisis, refused to help because of legal niceties that at other times it willingly ignored. But in the teeth of the worst trouble, it always moved to relieve the crisis. In the summer of 2011, for instance, when tensions came to a head over Spain's budget and banking shortfalls, the ECB set aside its past reluctance to buy the debt of these troubled countries, at once easing their and the market's acute liquidity shortages and concerns. It has followed that policy since—and it will likely continue to do so. ECB president Mario Draghi has said that the bank will do whatever it takes to secure the currency and its zone. He and everyone else at the ECB have a powerful personal motivation to do so, too, since without a euro, they know that there would be no need for a European Central Bank—or their jobs.<sup>2</sup></p>
<p>Berlin, as leader of Europe's most significant and viable economy, seems entirely committed to protecting the euro and its zone from any dissolution or dismemberment. It is noteworthy in this regard that for all the strains and debate in Germany's September election, the voters overwhelmingly returned the pro-Europe Angela Merkel to the chancellor's office. Similarly, the voters refused to give significant votes to any party that advocated German withdrawal. But more than personal and party commitments, Germany has little option but to support the euro and work to preserve the eurozone as it is presently constituted. Economic and financial imperatives compel it. Even if the vote this past September had gone less well than it did, the country simply is too tied to the euro and the union to turn away. Berlin may negotiate its best deal, but it knows that if it were to let the common currency fail, even in the part, it would do itself great economic and financial harm.</p>
<p>The vulnerability of German banking alone is impressive. By their own accounting, German banks and other financial institutions hold some €400 billion in Spanish, Greek, Portuguese, and Irish obligations alone. This exposure amounts to about 270% of the German banking system's tier 1 capital and 17% of Germany's gross domestic product (GDP). No doubt, exposure to Italian debt only pushes this vulnerability to greater extremes. Dissolution of the eurozone, the expulsion of some current members, and the unavoidable defaults such events would produce would consequently threaten Germany with such severe credit constraints that the economy would surely tip into a deep recession. The only way Berlin could avoid such an outcome would be to support the banks directly. There are, then, only three options: recession, direct support for the banks, or support for the periphery. Politically and financially, it is easier to marshal Europe to do the last than to face the others.<sup>3</sup></p>
<p>German industry has almost as much at stake in the euro and in the survival of the zone. To be sure, German business went into the currency union with great skepticism. But since, it has learned to love the euro. To see why, all one need do is consider what German industry would face in the absence of the common currency. Money now is pouring into Germany. It is, after all, the only viable large economy on the Continent. A separate deutschemark would by now have risen into the stratosphere. German business would have lost any pricing edge on global markets. Its exports would have suffered horribly. But because the euro encompasses weaker economies, it has not risen as high as an individual German deutschmark surely would have. The common currency has effectively saved German producers, and they know it. No doubt business leaders frequently brief Berlin on this economic fact of life.<sup>4</sup></p>
<p>Berlin also knows that a dissolution of the euro would steal the special trade advantage Germany has within Europe. Because Germany joined the euro when the deutschmark was cheap relative to German economic fundamentals, the common currency has effectively enshrined a competitive pricing edge for German producers across the entire zone, especially compared to producers in Europe's periphery nations, which joined the euro when their respective currencies were dear. International Monetary Fund (IMF) data show that these currency differences initially gave German producers a 6% pricing advantage over their Greek, Spanish, and Irish competitors. But since subsequent developments have encouraged greater industry and investment in Germany while discouraging it in the disadvantaged periphery, that advantage has widened. Calculations using recent IMF data put Germany's pricing edge over these countries at double digits.<sup>5</sup></p>
<p>Rather than risk suffering on all these fronts, Berlin knows that it would do well to support the weak periphery and keep the broad eurozone intact. Bailouts and rescue packages might look large in the headlines, but ultimately they impose far lighter burdens than the economic and financial costs implicit in any eurozone dissolution, complete or partial. With this clear pressure and the commitment it engenders added to the political will elsewhere in Europe and the cooperation of the ECB, there is every reason to expect that the euro and the eurozone will survive for the foreseeable future, even as Europe's ongoing crisis drags on and periodically creates false, if understandable, fears of dissolution and default.</p>
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<p><sup>1</sup> See, &quot;The SDP 'Has to Negotiate' with Merkel,&quot; <i>Spiegel On Line</i>, September 25, 2013, and Anton Troianovski, &quot;Merkel's Next Challenge: Finding New Governing Partner,&quot; <i>The Wall Street Journal</i>, October 5, 2013.<br>
<sup>2</sup> Milton Ezrati, &quot;Europe's Queasy Statue Quo,&quot; Economic Insights, August 12, 2013.<br>
<sup>3</sup> &quot;On Being Propped Up,&quot; <i>The Economist</i>, May 25, 2013.<br>
<sup>4</sup> Ullrich Fichtner and Alexander Smoltczyk, &quot;Schauble's Search for a Way Forward,&quot; <i>Spiegel On Line</i>, September 26, 2013.<br>
<sup>5</sup> International Monetary Fund.</p>
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Mon, 11 Nov 2013 19:41:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/why-some-international-economies-need-more-structural-reforms.htmlWhy Some International Economies Need More Structural Reforms <div class="everything everything_0">
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<h3>While Japanese policymakers debate critical structural reforms known as the &quot;third arrow,&quot; similar measures will be key to sustainable growth and attractive investment opportunities in a number of other countries.&nbsp;</h3>
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<p>Japanese prime minister Shinzo Abe has a plan for economic revival, and, with typical Japanese symbolism, it relies on three arrows. Two of his three arrows have already been launched: unprecedented monetary easing to achieve a 2% inflation target and a large deficit-financed spending program. The first two arrows are fairly conventional policy prescriptions, acknowledging that the potential magnitude of the monetary easing is anything but conventional. The third arrow, which the market is eagerly anticipating, is structural reforms to unleash growth. Japan is notorious for its inflexible, overregulated, tradition-bound economy. For Japan, the third arrow is an imperative.</p>
<p>But Japan is not the only country looking to launch a so-called third arrow. Given that the world's major central banks outside of Japan have extended conventional and unconventional monetary policies about as far as they comfortably can and may be approaching the peak, a successfully implemented third arrow approach could launch the next push of momentum into the world economy. In most cases, it will take courageous and cooperative political leaders. While on balance many programs will ultimately be pro-growth, they may not be in the short term, nor will they be positive for all sectors of the economy. Identifying the implications will be important for positioning one's portfolio to take advantage of the inevitable upcoming changes.</p>
<p><b>How Third Arrows Can Spur a Bull Market</b><br>
We have seen a few arrows launched in Europe already, and they have helped inform our investment strategies. While the United Kingdom incorporated significant structural and fiscal reforms into its initial response to the 2009 downturn, British officials have continued to tinker with tax rates, both personal and VAT (value-added tax); the availability of credit; employment education; and research innovation. Most programs have been fairly incremental in nature, but they have provided support for U.K. economic growth and a positive tone for the U.K. equity market. (See Table 1.) Some sectors positively affected, such as real estate, have done exceptionally well, and were targeted in our investments. As for U.K. employment, it's the first time since 1999 that private-sector employment has grown faster than public-sector employment, according to GaveKal Research. It's those types of third arrow results that are structurally conducive to a bull market.</p>
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<p><b><span class="rte_txt_green">Table 1. Even Partial Structural Reforms Have Been Good for Stocks</span></b></p>
<p><i>US$ returns for the 52 weeks ended October 15, 2013</i></p>
<p><img title="Table 1. Even Partial Structural Reforms Have Been Good for Stocks" src="/content/dam/lordabbett/en/images/articles/charts/whysomeintleconomies_table1.gif"></p>
<p><i><b>Source:</b> Source: Bloomberg. Data as of October 15, 2013.<br>
Sharp market fluctuations can materially change the performance of equity markets. During other time periods, the equity markets may have experienced negative performance.<br>
<b>Past performance is no guarantee of future results.</b><br>
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.<br>
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.<br>
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. These risks can be greater in the case of emerging country securities.</i></p>
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<p>&quot;Structural reform&quot; was a key phrase that European Commission president José Manuel Barosso used last year, when he pointed out the European Union was moving away from more austerity and into the development of &quot;pro-growth&quot; policies to deal with Europe's lingering recession. While the actual reforms have been spotty up until now, this proclamation was the turning point in how investors viewed the European equity markets, and it significantly lowered the perceived European risk premium.<sup>1</sup> Unfortunately, political instability and rudderless leadership in a number of countries have delayed what we believe will be inevitable economic reform.</p>
<p><b>Keep Your Eyes on Mexico</b><br>
It's not just the developed world struggling with reform. One of the more bold third arrow approaches being launched is in Mexico, where the three main political parties, together with the new president, all agree that the economy is hampered by structural shortcomings in productivity and infrastructure. In a sign of solidarity, they have signed the &quot;Pact for Mexico,&quot; which details an ambitious agenda of reform, focused on labor laws, wage policies, education, antitrust issues, infrastructure, and, most important, energy reform. It's so massive that the cost/benefit mix by industry will be complicated. But there seems to be ample room to identify winners and losers as this far-reaching third arrow gets launched over the next few years.</p>
<p><b>Further Reforms Needed in Japan</b><br>
Which brings us back to Japan and the imperative of Abe's third arrow. The initial launch is upon us with the hike in consumption tax in 2014. Many investors fear the economic momentum provided by the first two arrows will be derailed with this tax hike. We would likely agree if further reforms were not implemented. However, if sustainable economic growth, not continuously higher taxes, is the only way out of Japan's self-induced fiscal trap, then there must be more. As we have seen over the last 12 months, structural economic reforms are a great tonic for equity markets, and there will be winners and losers for us to identify. With that in mind, an alternative way to view Abe's tax hike is that he understands that Japanese economic revival is not just about printing and spending money, and, most important, that he has the necessary political will to fully launch the third arrow in time.</p>
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<p><sup>1</sup> Risk premium is generally defined as the return over and above the risk-free rate of return that an investor expects in exchange for each additional unit of risk. According to Markowitz portfolio theory, rational investors accept additional risk only if they expect a greater return.<br>
<sup>2</sup> The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange.<br>
<sup>3</sup> The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange.<br>
<sup>4</sup> The Euro STOXX 50 Index, Europe's leading blue-chip index for the eurozone, provides a blue-chip representation of super-sector leaders in the eurozone. The index covers 50 stocks from 12 eurozone countries.<br>
<sup>5</sup> The Mexican IPC index is a capitalization-weighted index of the leading stocks traded on the Mexican Stock Exchange. Note: Buoyed by proposed structural reforms and a rapidly closing wage gap with China, Mexico's stock market was one of the best-performing major markets in the world in 2012.</p>
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Tue, 5 Nov 2013 15:12:00 -0500http://www.lordabbett.com/content/lordabbett/en/perspectives/economicinsights/time-to-rediscover-emerging-markets.htmlTime to Rediscover Emerging Markets<div class="everything heading">
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<h3><span class="articlePhrase">Many developing economies still have room for solid growth, and recent market action has created attractive debt and equity valuations.</span></h3>
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<p>It is easy these days to generate pessimism about emerging market investments, and it is almost surely wrong, too. To be sure, there are plenty of worries surrounding these markets. Growth rates are slowing, inflationary problems have emerged in some places, capital flight has affected others, and where China is concerned, there are suggestions of demographic problems and asset bubbles. But it would be a mistake to tar one market for the problems in another, as many seem to do these days. These economies, and their markets, are remarkably diverse. It would be an even bigger mistake to ignore the ample opportunity for growth left in these economies, especially since the asset underperformance of late has created some very favorable valuations.&nbsp;</p>
<p>Assets prices in emerging economies, both bonds and equities, have suffered of late for two basic reasons. The most immediate is the threat of tapering of bond purchases by the Federal Reserve that would curtail the otherwise generous flow of liquidity it has long provided global markets. Investors, understandably, worry that asset pricing has depended heavily on this liquidity and have, naturally, sought safety at the least hint of the slightest interruption. Investors have, accordingly, pulled back, especially from emerging markets, where information is often scarce and where there is a history of great volatility. The second concern is more fundamental. The pace of real growth in these emerging economies has slowed, raising questions about earnings prospects and the health of their finances, public and private.<sup>1</sup></p>
<p>On both counts, the negative response has gone too far. Take the tapering, for instance. Fed chairman Ben Bernanke had often indicated that the Fed would taper only gradually and would turn to subsequent measures only after a long time, waiting until 2015 at the earliest to begin raising interest rates, and then only slowly from still accommodatingly low levels. Unless markets are without any fundamental support and are truly strung out on this flow of liquidity, such a path was never likely to undercut them as dramatically as recent reactions would suggest. Nor were the first stages of tapering (even if it had occurred when it was expected, which it did not) the stuff of which shocks are made. It was suggested that if the Fed moved at all, it would reduce its bond purchase from $85 billion a month presently to $70–65 billion—still an ample flow of liquidity. And as it is, the Fed still has not even begun the policy change.<sup>2</sup></p>
<p>To be sure, Bernanke is scheduled to leave office in the new year, to be replaced in all likelihood by Janet Yellen, the Fed's current vice chair. She could, of course, change policy more quickly than Bernanke intended. But that is highly unlikely. After all, she has worked hand in glove with Bernanke to create the present gradualist approach. In the unlikely event that she would want a change, she would have to shift many of the members of the Federal Open Market Committee (FOMC) to do so. Since they, too, are parties to the present policy, it is hardly likely that she could do that. Moreover, her votes at past FOMC meetings suggest that she is more likely to remain accommodative for longer than Bernanke would have.<sup>3</sup></p>
<p>The underlying economic fundamentals in emerging markets, too, though much changed from the salad days earlier in this century, are far less threatening than recent market responses imply. This is no place to review prospects for the long, diverse list of emerging economies and markets, especially because each has its own strengths and weaknesses. But it is possible to generalize that these economies, if no longer expanding at the breakneck pace they once were, still have much greater growth potential than the developed economies, the best of which are exhibiting only anemic rates of expansion. The commodity-based economies probably present greater reason for concern than the more broadly based emerging economies, those that are adjusting to the unfolding fundamentals of slower growth, for instance, and the challenge of the still less developed frontier economies. A cursory comparison among the well-known BRIC economies—Brazil, Russia, India, and China—might illustrate these general points, though the overall emerging universe is much broader and remarkably diverse.<sup>4</sup></p>
<p>Russia and Brazil lean toward the commodities side of this division. The former, in particular, has made itself highly and needlessly dependent on oil and gas. Half the government's revenues, in fact, come from oil and gas and at least that much of the country's export earnings. Were it not that the current tensions in the Middle East have pushed up oil prices, despite the global growth slowdown, the Russian economy would be struggling, which to a degree might explain the Kremlin's geopolitical strategies. In such a state, Russia's economy, and hence most of the assets priced in it, look highly vulnerable.<sup>5</sup></p>
<p>Brazil's situation is less extreme. It is more thoroughly diversified among different commodities than is Russia and more thoroughly diversified generally as an economy. But Brazil's still-heavy dependence on commodities makes it susceptible to the slow-growth global economic environment that will also surely persist. Still more, much of what previously looked like domestic development in Brazil now reveals very shallow roots. Some years ago, many saw broad-based development in the remarkable progress the country had made lifting people out of poverty. But it has become increasingly apparent that those gains came less from development than from the government's redirection of commodity export earnings to poorer families through the &quot;family allowance program.&quot; Now with the abatement in commodity-export earnings, the government can no longer sustain this flow of support. Poverty has risen back toward its old levels, social unrest has increased in tandem, and so also has outright rioting. In this unsettling revelation, many now glimpse the old Brazil, from before the country seemed to adopt a more open, free-market orientation, with even the old problems of inflation beginning to return.<sup>6</sup></p>
<p>In contrast, the slowed economic growth in India, China, and the like looks much less threatening. India has, of course, suffered an economic setback from the global slowdown and the outflows of global &quot;hot&quot; money during the world's recent tapering tantrums. But on a more positive side, India has concentrated more on domestic development than many emerging economies and has fostered an active middle class. No doubt India's vibrant democracy would have precluded a narrower development path, even if the authorities had wanted to pursue one. India's recent reemphasis on infrastructure spending, something the economy badly needs, reinforces that emphasis on domestic development. This orientation likely will, in time, help reduce the economy's vulnerability to global economic swings. Similarly, a recent decision by the Reserve Bank of India to allow more foreign financial institutions into the country will likely, eventually, reduce the economy's vulnerability to hot money flows.<sup>7</sup></p>
<p>To be sure, India's overall real pace of growth has slowed from 8%-plus a year earlier in this century to 3.2% more recently, with an official forecast of 5.3% for next year. But even accepting the slowdown, the country's domestic development promises at least to maintain the new reduced growth rate, if not in every quarter than generally, and possibly enhance it. Meanwhile, investors should not miss the fact that such growth, though slower than previously, is still twice the pace presently maintained by the United States and that much faster than Europe's.<sup>8</sup></p>
<p>China, too, has slowed. In part, the reduced rate of Chinese growth reflects the global slowdown in its export sales. But the slowdown also reflects Beijing's farsighted policy to reorient its economy from a purely export-dependent growth model to one with a broader base that includes domestic development. Despite its tendency to slow the country's pace of growth, the government has committed itself to this pro-domestic reorientation. It knows exports can no longer serve the role they once did. Indeed, Beijing has noted more than once that Chinese exports during the last 20 years have gone from a negligible part of the global mix to fully 12% of all exports sold in the world. Chinese officials know that this figure cannot rise to 24% anytime soon, if ever. Domestic development, thus, is imperative.<sup>9</sup></p>
<p>Some skeptics, however, question whether China can sustain even a slowed pace of growth, whatever the shift toward domestic development. These skeptics point at times to the aging of China's population due to the country's long-standing one-child policy, and they see a time when the country will face troubles implicit in an overhang of elderly and a relatively reduced work force to support it. Though this is not a small issue, it is prone to exaggeration, especially for the years immediately ahead. China is indeed aging, but the working-aged proportion of its population is still much larger relative to its retired population than, say, in the United States, and still larger than in Europe, which has even an older demographic. China will have a relative abundance of labor compared with the developed economies for at least a decade to come.</p>
<p>Other skeptics point to China's overbuilt residential real estate, and they worry that the country will suffer generally as this bubble will burst eventually. It is easy for Americans, still smarting from their own recent real estate bust, to see disaster in such circumstances. But China's situation is different from that in the United States during 2007–08. Chinese homeowners are not nearly as leveraged as were their American counterparts. In China, by law, a buyer most put down at least 20% on his or her first home and 50% on a second home. The debt burden in China lies less on households than on the provincial governments that were party to the development. Though this debt overhang is hardly welcome or harmless, it is much easier for the central government to handle than the household debt was for the authorities in the United States during its real estate bust. It is better circumscribed, too.<sup>10</sup></p>
<p>Meanwhile, China faces an imperative that will force the authorities to do whatever is necessary to maintain relatively rapid growth rates. According to the central government, approximately a million Chinese a month migrate from the countryside into the cities. To give work to this flow of jobseekers, the country must grow at 6% a year at least. Having staked its legitimacy on its ability to provide people with jobs and economic hope, the government in Beijing cannot accept failure on this front. It is well aware that slower growth will create social discord that it can ill afford, and, if recent Chinese history is any indication, riots as well. Faced with this political imperative, more manageable demographics than the skeptics fear, and more contained real estate troubles, it looks as though China will make its targeted 6–7% annual rate of real growth. The figure, to be sure, is well down from the 10–12% rate of the not too distant past, but it is still more than three times the pace likely in the United States.<sup>11</sup></p>
<p>Against these admittedly uneven prospects, emerging markets offer very attractive valuations. Sovereign emerging market debt, for instance, pays a handsome yield premium. With a duration of less than five years, the index of such bonds offers yield spreads of 500 basis points or more over comparable Treasuries. That is a wider spread than junk bonds in the domestic U.S. market, even though this sovereign emerging markets index has a 'BBB' average rating. On top of this attraction, two additional considerations stand as noteworthy. First, most of these countries have stronger finances than the United States. China, for instance, has more than $3.0 trillion in foreign reserves, while, on average, emerging economies have public debt outstanding equal to only 35.5% of their gross domestic product (GDP). That is about one-third the relative burden faced by the United States. Even India, one of the most indebted in the emerging world, has a public debt burden of 68.3% of its GDP, still almost one-third lower than America's burden. Second, with adequate growth prospects even at current reduced rates, chances are that the currencies of these countries will appreciate; certainly that is a greater likelihood than further depreciation.<sup>12</sup></p>
<p>If anything, valuations on emerging market equities are more compelling. As a whole, the benchmark MSCI Emerging Markets Index<sup>13</sup> carries a price about 10.5 times the consensus expectations on earnings for this year. That amounts to a discount of almost 35% from the price-to-earnings multiple on the overall MSCI EAFE Index<sup>14</sup> of developed market equities. The relationship between these two valuation gauges has varied considerably over time. Emerging market multiplies have at times risen to equal that of developed markets. At their lows (during the Asian contagion crisis of the late 1990s), they fell to half the developed markets' multiple. But within this admittedly wide range, the probabilities going forward suggest that the difference between these two multiples is more likely to narrow than widen, especially for those markets pursuing broad-based development. It is worth noting, too, that these attractive valuations exist even as many of these emerging economies maintain growth rates at multiples of those in the developed economies, with stronger finances as well as better long-term prospects.</p>
<p>There are risks, of course—there are always risks. But valuations alone suggest that investors give emerging bonds and equities a second or third look, especially those economies pursuing broad-based development. As ever, these investments are not for everyone—not for those without tolerance for volatility and not for those with a short-time horizon that cannot wait for valuation effects and favorable fundamentals to develop. But for others, a well-diversified portfolio of emerging market assets, chosen selectively from a diverse universe that goes well beyond the BRIC countries, offers an opportunity that warrants attention.</p>
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<p><sup>1</sup> For detail, see, J. J. Zhang, &quot;Emerging-Market Fears Hide Enticing Valuations,&quot; <i>Market Watch</i>, August 16, 2013; Reuters, <i>Update</i>, September 6, 2013; and Samuel Rines, &quot;Hitting a BRIC Wall,<i> The National Interest</i>, October 17, 2013.<br>
<sup>2</sup> Federal Reserve.<br>
<sup>3</sup> Federal Reserve.<br>
<sup>4</sup> &quot;Breaking the BRIC Piggy Banks,&quot; <i>The Economist</i>, October 11, 2013.<br>
<sup>5</sup> &quot;When Giants Slow Down,&quot; <i>The Economist</i>, July 27, 2013.<br>
<sup>6</sup> For more detail, see, Liam Denning, &quot;Shutting Down Emerging Markets,&quot; <i>The Wall Street Journal</i>, September 30, 2013; Blake Schmidt, &quot;Brazil Real Drops on Speculation Central Bank Will Limit Advance,&quot; Bloomberg, October 14, 2013; Thierry Ogier and Lucien Chauvin, &quot;Brazil Unveils Own 'Tapering' Plan,&quot; <i>Emerging Markets</i>, October 10, 2013; and Milton Ezrati, &quot;Same Old Samba for Brazil,&quot; <i>Economic Insights</i>, November 15, 2012.<br>
<sup>7</sup> Elizabeth Owen, &quot;India Opens Doors to Foreign Banks,&quot; <i>Emerging Markets</i>, October 12, 2013.<br>
<sup>8</sup> Owen, <i>op. cit.</i><br>
<sup>9</sup> Elliot Wilson, &quot;China Slowdown Threatens Asia Crisis,&quot; <i>Emerging Markets</i>, October 12, 2013, and Shamim Adam, &quot;China-to-India Price Jump Risks Growth as World Outlook Dims,&quot; Bloomberg, October 14, 2013.<br>
<sup>10</sup> Ibid.<br>
<sup>11</sup> Ibid.<br>
<sup>12</sup> Stephen Yeats, &quot;Mapping and Navigation the Emerging Market Fixed Income Universe,&quot; <i>SSgA Capital Insights</i>, September 2013.<br>
<sup>13</sup> The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2006, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.<br>
<sup>14</sup> The MSCI EAFE<sup>®</sup> [Europe, Australasia, Far East] Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada.</p>
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Mon, 4 Nov 2013 18:30:00 -0500